Cash Conversion Cycle (CCC) Defined
This metric, which is also referred to as the cash cycle or the net operating cycle, looks at the time a business takes to recover its investment in inventory to eventually sell. The process starts from selling its goods, collecting on outstanding receivables or invoices, and satisfying its operating costs with the sale proceeds. It’s normally measured in days to determine the company’s financial health.
The less time necessary to complete the CCC, the healthier a company is financially because it means the business’ money spends less time tied up in inventory or collecting on outstanding inventory. It’s important to be mindful that different industries have different CCC time frames. Generally speaking, most calculations are done on either a quarterly (90 day) or an annual basis (365 days).
How to Calculate CCC
The formula is as follows:
(CCC) = Days Inventory Outstanding (DIO) + Days Sales Outstanding (DSO) − Days Payable Outstanding (DPO)
It can be broken down into three different stages:
Stage 1
Days Inventory Outstanding (DIO) looks at how many days the inventory takes to sell to customers. It’s calculated as follows:
DIO = (Average Inventory (AI) / COGS) x Time-Frame (In Days)
AI = 1/2 x (BI + FI)
BI = Beginning Inventory
FI = Final Inventory
It’s important to define COGS, taken from the Income Statement, which is Cost of Goods Sold or the costs personally connected to creation of goods or services (raw materials, labor or electricity). The lower the number, the faster a business is selling its goods.
Stage 2
Days Sales Outstanding (DSO) measures the time it takes the business to collect payment from all outstanding sales completed.
DSO = Average Accounts Receivable (AAR) / Daily Revenue
AAR = 1/2 x (SAR + FAR)
SAR = Starting AR
FAR = Final AR
Accounts Receivable are what companies record on their balance sheet to keep track of what customers owe for the goods delivered or services rendered. The lower the results, the better the company’s cash position is because they’re able to satisfy outstanding invoices.
Stage 3
Days Payable Outstanding (DPO) is the third and final stage that calculates how much businesses owe to their suppliers the business has sourced input materials from, within the time frame the suppliers’ invoices are due.
DPO = Average Accounts Payable (AAP) / Daily COGS
Where:
AAP = 0.5 x (SAP + FAP)
SAP = Starting AP
FAP = Final AP
COGS = Cost of Goods Sold
There are different ways to interpret the DPO result. A low DPO means the business is taking care of its bills from suppliers. However, potential investors, internal managers, and supervisors can see if the business can either negotiate lengthier payment terms while still maintaining good terms or if the company negotiates early payment terms or invests the money on a short-term basis to earn more for the company before paying suppliers’ bills. A high DPO, after an investigation of a company’s financials, might show the company is taking longer than its peers to pay creditors.
While calculating the CCC is relatively straightforward, the more complex process is interpreting it correctly and using judgment for a business based on industry averages and how the numbers relate to current economic conditions.
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