The 3 Main Drivers Of Your Cash Conversion Cycle

March 23rd, 2020

The Cash Conversion Cycle (CCC) is the single most important indicator of a company’s operating efficiency and liquidity. It represents the amount of time between when a firm 1) pays cash to purchase its initial inventory, and 2) when it receives cash from the sale of the output produced from that inventory (the green line shown below):

Lots of times the financing out there from Banks and Lenders is not readily available, so you need to find ways of shortening your Cash Conversion Cycle to unlock the cash flow that is “trapped” in there.

There are 3 main components of the Cash Conversion Cycle:

  • Days Inventory Outstanding (DIO)
  • Days Sales Outstanding (DSO)
  • Days Payable Outstanding (DPO)

Days Sales Outstanding (DSO) — this is the length of time required to convert the firm’s receivables into cash, or how long it takes to collect cash from a sale

Days Payable Outstanding (DPO) — the average length of time between when you purchase from suppliers & vendors and when you pay them

Days Inventory Outstanding (DIO) — the average time required to convert materials into finished goods and then to sell those goods

The formula for Cash Conversion Cycle is therefore:

You can calculate the Cash Conversion Cycle every month, quarter, or every year. You just need to calculate the averages for Inventory volume, Accounts Receivable (AR) volume, and Accounts Payable (AP) volume and take the corresponding number of days for the period.

Now let’s go through an example on how to calculate your Cash Conversion Cycle. Let’s start with the DSO. First you need to figure out what your “Credit Sales” are (which is in the denominator) and for that we’re going to look at your Income Statement:

Not all your Credit Sales are on “Credit”, i.e. on net terms. Some of your sales are processed upfront with credit cards so you need to exclude those. To calculate your Credit Sales, here is the formula:

The average quarterly credit in this example is $765,000.

Now let’s take a look at the average quarterly Accounts Receivable Volume, which you can get from the Balance Sheet:

The average Accounts Receivable volume for the quarter is $543,333.

So your DSO is: 65 days.

You can do the same calculation for your DIO and DPO and you will find the following results:

So now what is the cash flow impact of reducing your Cash Conversion Cycle? In the “Original” column, we can calculate your Working Capital:

Working Capital =
Current Assets (Receivables + Inventory) – Current Liabilities (Payables).
= $440,000

Let’s say you’re able to reduce your DSO from 65 days to 25 days and extend your payable days from 56 to 60 days. We can re-arrange the formula to back into our new Accounts Receivable volume and Accounts Payable Volume with the formulas below.

Our new Working Capital is $79,615.

Shortening your receivables days and getting more flexible terms on your payable days from suppliers & vendors can have a massive impact on your Free Cash Flow (FCF), namely $360,385!

Make sure you calculate and monitor your Cash Conversion Cycle components every month or at least every quarter, so you can spot any worsening trends early on:

That’s it for now, and if you wish to get access to the spreadsheets or presentation or video, please email me at jfreuler@aurarise.com and please share the article if you think other businesses can benefit from this post!

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