Maintaining optimal financial health is essential for business sustainability and growth, and one of the areas involves keeping an eye on your cash flow. To get a clear picture of how well your business is managing its cash, you must understand how long it takes the business to convert their inventory into cash. This is known as the cash conversion cycle (CCC).
By understanding and optimizing your cash conversion cycle, you can ensure your business maintains good liquidity and that there is always enough cash to invest in new opportunities, cater to its responsibilities, and maintain its sustenance drive.
In this article, we will explore what the cash conversion cycle entails, the components, and how to measure and optimize it better to promote your business growth.
What is the Cash Conversion Cycle?
The Cash Conversion Cycle (CCC) is the metric that measures the time (in days) that it takes a company to convert its investments in inventory and other resources into cash inflows from sales. The cycle starts when the business invests or spends money on purchasing or producing goods and ends when it receives payment.
CCC reflects the efficiency of a company’s operations and working capital management. It helps the company understand how efficiently they are managing their cash flow. When the CCC is shorter, it means the business gets its cash back quickly, which indicates a reduction in the need for borrowing and an increase in liquidity. On the other hand, when the CCC is longer, it indicates the company takes more time to recover its money in cash from its investments. This entails insolvency in small businesses. The shorter the CCC, the better it is for the business.
Components of a Cash Conversion Cycle
The Cash Conversion Cycle has three main components; each of which helps you understand an aspect of the cycle. Understanding the three components gives you an overview of your business CCC. Let’s look at what each of the components entails:
1. Days Inventory Outstanding (DIO)
DIO measures the average number of days a company takes to sell its inventory. To calculate the DIO, divide the average inventory by the cost of goods sold (COGS) and multiply by 365 days.
If the DIO is low, it indicates that your business can quickly turn its inventory into sales, which is generally a good sign. It shows a high demand for your goods or services and that your inventory is managed properly. Conversely, if the DIO is high, it indicates your company is struggling to sell its products, which is not a good thing. This leads to excess inventory and potential cash flow issues.
2. Days Sales Outstanding (DSO)
DSO represents the average number of days it takes for a company to collect payment after making a sale. You calculate DSO by dividing the accounts receivable by total credit sales and multiplying by 365 days.
A lower DSO indicates that your company collects its payments quickly, which enhances its cash flow. On the other hand, a higher DSO indicates that your company is taking longer to collect payments. This can tie up cash, which can create liquidity problems. To maintain a low DSO, you must maintain efficient credit management and collection processes.
3. Days Payable Outstanding (DPO)
DPO measures how long it takes your company to pay its suppliers. It is the average number of days a company takes to settle its bills with the suppliers. To calculate DPO, divide the accounts payable by the cost of goods sold (COGS) and multiply by 365 days.
If your DPO is high, it indicates that your company takes a longer time to settle its suppliers, which can help conserve cash in the short term. However, taking too long to pay suppliers might strain relationships and lead to less favorable terms during negotiation. A lower DPO shows that the company pays its suppliers more quickly, which is beneficial for maintaining good supplier relationships but leads to less cash on hand, which can be utilized for other purposes.
Analyzing these three components together gives you a comprehensive view of your business’s cash conversion process.
How Do Measure Your Cash Conversion Cycle?
To measure your cash conversion cycle, add the value of your DIO and DSO and subtract DPO from the sum. The formula is represented as CCC = DIO + DSO + DPO.
Here are the steps involved:
Step 1: Calculate DIO
Firstly, identify the average inventory for a defined period (beginning inventory + ending inventory / 2) and determine the cost of goods sold (COGS).
DIO = Average Inventory × 365
Cost Of Goods Sold
Example:
If a company has an average inventory of $100,000 and its cost of goods sold (COGS) is $500,000, the DIO would be:
DIO = 100,000 × 365 = 73 days
500,000
Step 2: Calculate DSO
First, find the total accounts receivable for the period and the total credit sales for the period. The formula for DSO is:
DSO = Accounts Receivable × 365
Total Credit Sales
Example:
If a company’s accounts receivable is $200,000 and total credit sales are $1,000,000, the DSO would be:
DSO = 200,000 × 365 =73 days
1,000,000,
Step 3: Calculate DPO:
First, calculate the accounts payable for the period (beginning accounts payable + ending accounts payable / 2). After that, proceed to calculate DPO.
DPO = Accounts Payable × 365
Cost of Goods Sold
Step 4: Calculate CCC
Once you have calculated the DIO, DSO, and DPO, you can determine the CCC using the following formula:
CCC=DIO+DSO−DPO
Example Calculation:
Using the example figures above:
- DIO: 73 days
- DSO: 73 days
- DPO: 110 days
CCC = 73+73−110 = 36 days
This result indicates that it takes the company 36 days to convert its investments in inventory and other resources into cash flows from sales.
How To Optimize Your Cash Conversion Cycle
Here are the major ways you can optimize your cash conversion cycle to maintain optimal liquidity in your business.
1. Improve Your Inventory Management
The shorter it takes a business to sell its inventory, the better the CCC is. Inventory management is one of the major steps a company can take to keep its cash conversion cycle manageable. Purchase what your company needs and use all the available tools to ensure you quickly sell off your inventory. Minimize overstocking inventories as it helps to reduce holding costs by adopting just-in-time (JIT) inventory systems. Utilizing inventory forecasting and demand planning tools can help you predict sales trends and avoid overstocking.
2. Improved Payment Collection
How quickly your customers pay for goods purchased directly influences your CCC. Set up a tight credit policy system that encourages customers to pay quickly and reduces late payments. You can do this by offering early payment incentives, such as discounts and bonuses.
Adopt efficient automated invoicing processes and robust follow-up procedures to send reminders to customers to pay for their purchases. You can also set policies that discourage late payments.
3. Efficient Management of Payables
As a company manager or business owner, learn to negotiate longer payment terms with suppliers to delay cash outflows without affecting your relationship with them. Make full use of agreed-upon credit terms and avoid early payments unless there are significant discounts. Doing this helps you maintain cash reserves for a longer period of time. Additionally, review supplier contracts regularly and seek more favorable terms to improve your days payable outstanding (DPO).
4. Adopt Technology
Employing technology in all these areas greatly enhances efficiency. Adopt software that provides real-time insights into your receivables, payables, and inventory. Automating routine tasks such as inventory management and reordering, payment processing, and invoicing reduces errors and helps save time. With efficient software, you can easily gather all these data in a central place for easy analysis and monitoring, which is essential for decision-making.
Final Words
Mac Adebowale Professional Service is here to guide you and provide actionable strategies to improve your CCC, maintain optimal liquidity, and capitalize on new business opportunities. Contact us at emails@macadebowale.com or macadebowaleadvisory@gmail.com, and let’s get started.
