Cash Conversion Cycle (CCC)

What Is the Cash Conversion Cycle (CCC)?

The cash conversion cycle (CCC) is a metric that communicates the time (measured in days) it takes for a company to change over its investments in inventory and different resources into cash flows from sales. Additionally called the Net Operating Cycle or essentially Cash Cycle, CCC endeavors to measure how long each net input dollar is tied up in the production and sales process before it gets changed over into cash received.

This measurement requires some investment the company needs to sell its inventory, how long it requires to collect receivables, and how long it needs to pay its bills.

The CCC is one of several quantitative measures that assist with evaluating the effectiveness of a company's operations and management. A trend of decreasing or consistent CCC values over different periods is a decent sign while rising ones ought to lead to more investigation and analysis in light of different factors. One ought to bear in mind that CCC applies just to choose sectors dependent on inventory management and related operations.

The Formula for Cash Conversion Cycle (CCC)

Since CCC involves calculating the net aggregate time involved across the over three stages of the cash conversion lifecycle, the mathematical formula for CCC is addressed as:
$\begin &CCC = DIO + DSO - DPO \ &\textbf \ &DIO = \text \ &\text{(also known as days sales of inventory)} \ &DSO = \text \ &DPO = \text \ \end$
DIO and DSO are associated with the company's cash inflows, while DPO is linked to cash outflow. Thus, DPO is the main negative figure in the calculation. One more method for looking at the formula construction is that DIO and DSO are linked to inventory and accounts receivable, respectively, which are considered as short-term assets and are taken as positive. DPO is linked to accounts payable, which is a liability and in this way taken as negative.

Calculating CCC

A company's cash conversion cycle broadly travels through three distinct stages. To work out CCC, you really want several things from the financial statements:

• Revenue and cost of goods sold (COGS) from the income statement
• Inventory toward the beginning and end of the time span
• Account receivable (AR) toward the beginning and end of the time span
• Accounts payable (AP) toward the beginning and end of the time span
• The number of days in the period (e.g., year = 365 days, quarter = 90)

The principal stage centers around the existing inventory level and addresses what amount of time it will require for the business to sell its inventory. This figure is calculated by using the Days Inventory Outstanding (DIO). A lower value of DIO is preferred, as it indicates that the company is making sales rapidly, implying better turnover for the business.

DIO, otherwise called DSI, is calculated in view of the cost of goods sold (COGS), which addresses the cost of acquiring or manufacturing the products that a company sells during a period.
$\begin &DSI=\frac{\text} \times 365 \text \ &\textbf \ &\text = \frac{1}{2} \times ( \text + \text ) \ &\text = \text \ &\text = \text \ \end$
The subsequent stage centers around the current sales and addresses what amount of time it requires to collect the cash produced from the sales. This figure is calculated by using the Days Sales Outstanding (DSO), what partitions average accounts receivable by revenue each day. A lower value is preferred for DSO, which indicates that the company can collect capital in a short time, in turn enhancing its cash position.
$\begin &DSO=\frac{\text}{\text}\ &\textbf\ &\text = \frac{1}{2} \times ( \text+\text ) \ &\text = \text \ &\text = \text \ \end$
The third stage centers around the current outstanding payable for the business. It considers the amount of money the company owes its current providers for the inventory and goods it purchased, and it addresses the stretch of time in which the company must pay off those obligations. This figure is calculated by using the Days Payables Outstanding (DPO), which considers accounts payable. A higher DPO value is preferred. By maximizing this number, the company holds onto cash longer, increasing its investment potential.
$\begin &DPO=\frac{\text}{COGS \text} \ &\textbf \ &\text = \frac{1}{2} \times ( \text + \text ) \ &\text = \text \ &\text = \text \ &COGS = \text \end$
Every one of the previously mentioned figures are available as standard things in the financial statements documented by a publicly listed company as a part of its annual and quarterly reporting. The number of days in the corresponding period is taken as 365 for a year and 90 for a quarter.

Everything the Cash Conversion Cycle Can Say to You

Boosting sales of inventory for profit is the primary way for a business to make more earnings. Be that as it may, how can one sell more stuff? In the event that cash is effectively available at regular intervals, one can churn out additional sales for profits, as continuous availability of capital leads to additional products to make and sell. A company can obtain inventory on credit, which results in accounts payable (AP).

A company can likewise sell products on credit, which results in accounts receivable (AR). In this way, cash isn't a factor until the company pays the accounts payable and collects the accounts receivable. Hence timing is an important part of cash management.

CCC follows the lifecycle of cash utilized for business activity. It follows the cash as it's previously changed over into inventory and accounts payable, then, at that point, into expenses for product or service development, through to sales and accounts receivable, and afterward back into cash close by. Basically, CCC addresses how fast a company can change over the invested cash from start (investment) to end (returns). The lower the CCC, the better.

Inventory management, sales realization, and payables are the three key ingredients of business. If any of these goes for a throw — say, inventory mismanagement, sales constraints, or payables increasing in number, value, or recurrence — the business is set to endure. Past the monetary value involved, CCC accounts for the time involved in these processes that gives one more perspective on the company's operating productivity.

Notwithstanding other financial measures, the CCC value indicates how effectively a company's management is using the short-term assets and liabilities to create and redeploy the cash and gives a look into the company's financial wellbeing with respect to cash management. The figure likewise evaluates the liquidity risk linked to a company's operations.

Special Considerations

In the event that a business has hit the appropriate notes and is effectively serving the requirements of the market and its customers, it will have a lower CCC value.

CCC may not give meaningful inferences as an independent number for a given period. Analysts use it to follow a business throughout various time spans and to compare the company to its rivals. Tracking a company's CCC over numerous quarters will show in the event that it is improving, maintaining, or worsening its operational proficiency. While comparing competing businesses, investors might take a gander at a combination of factors to choose the best fit. Assuming two companies have similar values for return on equity (ROE) and return on assets (ROA), it could be worth investing in the company that has the most reduced CCC value. It indicates that the company can create similar returns all the more rapidly.

CCC is likewise utilized internally by the company's management to change their methods of credit purchase payments or cash collections from debtors.

Illustration of How to Use CCC

CCC has a specific application to various industrial sectors in light of the idea of business operations. The measure has a great significance for retailers like Walmart Inc. (WMT), Target Corp. (TGT), and Costco Wholesale Corp. (COST), which are involved in buying and managing inventories and selling them to customers. All such businesses might have a high positive value of CCC.

Nonetheless, CCC doesn't apply to companies that don't have needs for inventory management. Software companies that offer computer programs through licensing, for instance, can understand sales (and profits) without the need to oversee stockpiles. Similarly, insurance or brokerage companies don't buy things wholesale for retail, so CCC doesn't apply to them.

Businesses can have negative CCCs, as online retailers eBay Inc. (EBAY) and Amazon.com Inc. (AMZN). Frequently, online retailers receive funds in their accounts for sales of goods that really belong to and are served by third-party sellers who utilize the online platform. Be that as it may, these companies don't pay the sellers following the sale however may follow a month to month or threshold-based payment cycle. This mechanism permits these companies to hold onto the cash for a longer period of time, so they frequently end up with a negative CCC. Also, assuming the goods are straightforwardly supplied by the third-party seller to the customer, the online retailer never holds any inventory in-house.

A Harvard Business blogpost credits the negative CCC as a key factor in Amazon's survival of the website bubble of 2000. Operating with a negative CCC turned into a source of cash for the company, instead of being a cost for it.

Highlights

• This measurement requires some investment expected to sell its inventory, the time required to collect receivables, and the time the company is permitted to pay its bills without incurring any punishments.
• CCC will vary by industry sector in view of the idea of business operations.
• The cash conversion cycle (CCC) is a metric that communicates the timeframe (in days) that it takes for a company to change over its investments in inventory and different resources into cash flows from sales.

FAQ

What Is the Cash Conversion CycleFormula?

Cash Conversion Cycle = days inventory outstanding + days sales outstanding - days payables outstanding.

How Does Inventory Turnover Affect the Cash Conversion Cycle?

A higher, or speedier, inventory turnover diminishes the cash conversion cycle. In this way, a better inventory turnover is a positive for the CCC and a company's overall productivity.

What Does the Cash Conversion Cycle Measure?

The cash conversion cycle (CCC) is one of several measures of management viability. It measures how fast a company can change over cash close by into even more cash close by. The CCC does this by following the cash, or the capital investment, as it is first changed over into inventory and accounts payable (AP), through sales and accounts receivable (AR), and afterward back into cash. Generally, the lower the number for the CCC, the better it is for the company.

What Does the Cash Conversion Cycle Say About a Company's Management?

At the point when a company — or its management — gets some margin to collect outstanding accounts receivable, has too much inventory close by, or pays its expenses too rapidly, it extends the CCC. A longer CCC means it requires a longer investment to create cash, which can mean insolvency for small companies.When a company collects outstanding payments rapidly, accurately gauges inventory needs, or pays its bills gradually, it shortens the CCC. A shorter CCC means the company is better. Extra money can then be utilized to make extra purchases or pay down outstanding debt. At the point when a manager needs to pay its providers rapidly, it's known as a pull on liquidity, which is terrible for the company. At the point when a manager can't collect payments rapidly enough, it's known as a drag on liquidity, which is likewise terrible for the company.