Cash Conversion Cycle

Introduction

Proper cash flow is very important for any organization to run its business operations smoothly and efficiently. Big multinational corporations face cash flow problems more often because of multiple reasons like inefficient sales, low profitability, investment in diverse businesses, high debts, etc.

No company wants to witness negative cash flow that puts their business in peril or risk. Now, to be on the top of the game, it’s crucial for a company to have a positive cash flow, resulting in healthy long-term growth. So, how long does a company take to reach the cash flow position?

Define cash conversion cycle

Cash conversion cycle refers to the time an entity takes to convert inventory investment into cash form. In simple terms, it’s the time taken by a company to attain cash flows after selling the inventory in the market. This metric explains the time an inventory endures when initiating the conversion till it goes off from the racks after sales.

Understanding cash conversion cycle

Simply known as net operating cycle, this metric states how much time the product took from converting inputs or investment into finished goods and sales proceeds. The cash conversion cycle process begins with splurging cash for purchasing the product. After receiving the product, it goes into the inventory section waiting to hit the market shelves.

Once the customer makes a purchase, they’ll receive an invoice asking them to pay for the product. Upon fulfilling the payment, the earnings enter the company’s balance sheet under the sales section. The cash conversion cycle paints the big picture to the company, computing the period it took from the date of inventory purchase till they receive all the account receivables.

While the assumed belief is that a cash flow is simply generating more income via sales than the cost incurred in the making. But there’s more than what meets the eye. A good cash flow ensures that the company doesn’t need to break their cash reserves to carry their existing and future operations.

If a company fails to maintain a healthy cash flow, it can create a volatile situation in the market, making investors anxious about their investments. Irrespective of the company’s past performance, the investors end up pulling out all their investments. This can lead the company to fall on its knees, resulting in bankruptcy.

So, the company should have cash flow in such a way that even after meeting all the expenses, there should be some additional funds to invest in other desirable projects.

Purpose of cash conversion cycle

The easiest way to keep the cash flow consistent and positive is by enhancing the sales of the company. If the cash conversion cycle (CCC) is lower; it’s a green signal for the company because the time taken for conversion from inventory to sales is lesser. But it’s obvious in the case of a higher cash conversion cycle.

This financial tool plays a major role in letting the company know the cash availability in the business to make inventory purchases, for working capital needs, the dues to be taken care of, and more.

What does the Cash Conversion Cycle tell you?

The prime goal of any business is to get inventory production right, make its presence in the market, receive profits post sales, clear the accounts payable by offsetting with the accounts receivables. This cycle tells the company how well they are using the working capital resources and business assets to generate returns.

Additionally, it also tells you in which business categories the cash is flowing and the turnaround time to convert the invested capital into profits. The company can use the CCC information to compare with other competitors in the same business line. This gives the company the snapshot of where they stand in the functioning industry.

Formula and computation of cash conversion cycle

The formula of cash conversion cycle is the addition of Days Inventory Outstanding and Days Sales Outstanding Minus Days Payable Outstanding.

Cash Conversion Cycle (CCC) = Days Inventory Outstanding (DIO) + Days Sales Outstanding (DSO) – Days Payables Outstanding (DPO)

Here’s a simple example of a cash conversion cycle. ABC Limited has an inventory of Rs 5000, net credit sales of Rs 25,000, accounts receivables of Rs 10,000, account payables of Rs 4000, and cost of sales of Rs 80,000. So, what is the cash conversion cycle of this company?

DIO = 4000/80000 * 365 = 18 days approximately

DSO = 10000/250000 * 365 = 146 days approximately

DPO = 5000/80000 * 365 = 23 days approximately

CCC = 18 + 146 - 23 = 141 days

Conclusion

Cash conversion cycle is a financial tool used by the companies to track their cash flow status in the business. It tells the debts the company has to take care of from the returns it earns in the form of receivables. This metric can either be negative or positive, depending on the business performance and cash flows in the company. The lesser the CCC, the better the company’s performance in the respective financial year, vice-versa.

FAQs

Q1) Can a cash conversion cycle be negative?

Ans) Yes, cash conversion cycle can be negative due to various reasons like the company fails at delivering the deliverables on time, lesser sales, lack of leadership, etc.