What is the cash conversion cycle?
The Cash Conversion Cycle (CCC), also known as the cash cycle or net operating cycle, is used in management accounting to measure how long invested money remains tied up before it starts appearing in a company’s cash flow. It is a measure of liquidity risk when a business grows.
Put simply, the calculation tries to measure how long each net input unit of currency, such as a dollar, is tied up in production and sales, before sales materialize and it is converted into cash.
The calculation looks at how long it takes to sell inventory, collect receivables, and pay invoices (without facing late-payment penalties).
Good management is forever trying to reduce the cash conversion cycle, thereby freeing up cash and reducing financing costs.
The aim of studying the cash conversion cycle is to determine whether a firm’s credit purchase and credit sales policies are suitable to the business’ purposes and financial health. If the CCC points to a poor cash liquidity position, credit policies need to be changed.
Analysts compare the CCC readings of different companies in the same industry segment to determine how good (or bad) their cash management is.
Cash conversion cycle formula
The CCC is calculated by adding the days inventory outstanding to the days sales outstanding, minus the days payable outstanding.
CCC = Days Inventory Outstanding + Days Sales Outstanding – Days Payable Outstanding.
The CCC is calculated by following the money as it is initially converted into inventory and accounts payable (money owed to creditors), through sales and accounts receivable (money owed to the company by its debtors), and then back into cash.
Companies with a lower CCC number are in a better financial position compared to firms with higher numbers.
Imagine Sam’s Ball Bearings inventory sits in the warehouse for 10 days, and that it usually takes 20 days to collect on the sale of each order. Sam’s takes 20 days to pay invoices to its suppliers.
Using the above formula, Sam’s cash conversion cycle is:
Cash Conversion Cycle = 10 + 20 – 20 = 10 days.
This means that Sam’s generates cash from assets within ten days.
According to nasdaq.com, the cash conversion cycle is:
“The length of time between a firm’s purchase of inventory and the receipt of cash from accounts receivable.”
Video – The cash conversion cycle