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.
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Cash Conversion Cycle: How Does it Work?
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.
Formula for Calculating Cash Conversion Cycles
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.
- DIO – DIO refers to Days Inventory Outstanding, which is the measure of the average time it takes for a company to convert its inventory into sales. The formula for DIO is to divide average inventory by cost of the sold goods. The resulting figure should be multiplied by 365.
- DSO – DSO stands for Days Sales Outstanding, which is the average time that the company takes to collect its accounts receivables. The formula for it is given by dividing the average accounts receivable by total credit sales, multiplied by 365.
- DPO – Days Payable Outstanding or DPO is the average time it takes a company to clear its accounts payable. The average accounts payable is divided by the cost of goods, which is then multiplied with 365.
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.
Why Should You Analyse Cash Conversion Cycles?
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.
Can Cash Conversion Cycles be Negative?
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.
Advantages of Positive Cash Conversion Cycles
Enterprises maintaining a positive cycle can experience the following benefits from the same –
- The company does not need to depend on external agencies when it comes to its finances. It also leads to fewer bad debts.
- Businesses often face substantial challenges when it comes to storing unsold or unclaimed inventory. Better conversion means minimal leftover inventory, which, in turn, resolves storage and other associated problems.
- To ensure a faster collection of receivables from customers, businesses with positive cash conversion can incentivise the system. Thus, customers will start paying sooner to acquire better discounts.
Drawbacks of Positive Cash Conversion Cycles
The propensity to create positive cash cycles can also act as a drawback in some cases –
- Businesses may utilise cash to clear dues with suppliers first to create a positive cash cycle, without thinking about more immediate uses for that money.
- Cash conversion cycle does not represent the complete picture when it comes to a company’s management efficiency. This metric overlooks various factors, which are important when determining effectiveness.
Alternative Ways to Determine Cash Flow
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.