Businesses, especially smaller enterprises, often struggle to maintain their cash flow, thanks to long cash conversion cycles. Entrepreneurs are distinctly familiar with how cash conversion cycles work and how it affects their businesses. In the simplest of terms, such a conversion cycle refers to the period in which companies can transform their cash in hand into more cash.
A cash conversion cycle is a time (measured in days) that a company needs to convert its inventories and resources into cash through sales. This metric determines how long an investor’s money remains tied up in the business before resulting in concrete financial returns. Cash cycle and net operating cycle are other names for cash conversion cycle.
Keep in mind that this cycle does not simply measure the time it takes for a business’s products to sell but tracks how long it takes to collect the accounts receivables. It also indicates the period within which a company must settle its dues to avoid incurring penalties.
To determine the cash conversion cycle for a company, the following formula is utilised –
CCC = DIO + DSO – DPO
However, to comprehend this cash conversion cycle formula, understanding the related factors responsible is critical.
All of these factors are calculated in days, which is why the resulting cash conversion cycle also comes in days.
Consider an example where the concerned company’s DIO is 23, DSO is 16 and DPO is 13. Thus, as per the cash conversion cycle formula,
CCC = 23 + 16 -13
CCC = 26 days
Therefore, the company can transform its inventory into cash flow in approximately 26 days.
A cash conversion cycle can afford an insight into a company’s management. A steady decrease in the cash conversion cycle testifies effective management, thereby shortening the span between inventory acquisition and revenue generation. A company maintaining its cash conversion cycles can also be classified as well-managed.
However, if the conversion cycles keep rising, it can be indicative of management issues or other underlying problems within the business. In such a case, the business management needs to undertake proper analysis to determine the cause behind the lengthening cycles.
Cash conversion cycles can be either positive or negative, depending on when a business decides to clear its account payables. If the bills due are settled prior to collecting the receivables, the cash conversion cycle remains positive. However, if a company decides to postpone its liabilities to its suppliers until after acquiring the receivables, this would result in negative cash conversion cycles.
Although a positive conversion cycle is preferable, businesses can also function just as well with negative cycles. The feasibility depends largely on the circumstances and scope of the business. For instance, smaller businesses may find it difficult to delay payment to suppliers until collection of receivables. On the other hand, companies like Amazon can operate with negative cash cycles, since their suppliers are more than happy to accommodate such requests.
Enterprises maintaining a positive cycle can experience the following benefits from the same –
The propensity to create positive cash cycles can also act as a drawback in some cases –
While cash conversion cycles offer a distinct idea regarding the period between inventory acquisition and its conversion into cash, businesses often use another metric to measure its cash flow, known as cash conversion ratio. Instead of time, this metric pits the cash flow of a business against its net profit.
Companies with a resulting ratio of more than 1 can be defined as having impressive liquidity, while those below one may be facing cash flow shortages.
Cash conversion cycle is an important determinant of a business’s liquidity. It is one of the many metrics that management should analyse to decide whether a business is operating properly or not.