Working capital is crucial to the development and survival of any business. It’s so important that business owners and investment analysts have devised several tools for measuring a company’s ability to maintain working capital.
One such tool is known as the cash conversion cycle (CCC), cash flow conversion cycle (CFCC), or net operating cycle (NOC).
No matter which name you choose to call it, the metric tracks inventory turnover, telling business owners and investors how long it takes to turn a dollar’s worth of inventory into a dollar bill.
What is the cash conversion cycle?
The CCC is a liquidity metric that’s designed to show you the average number of days it takes your company to turn its inventory into cash. In other words, if you purchase $10,000 worth of inventory today, how long will it take you to sell all of it? A week? A month? A year? The CCC gives you a better understanding of the specific length of time your inventory takes to become liquid.
Most businesses have a positive CCC, but the length of their CCC can vary wildly based on their industry and sales process. For example, a car dealer is likely to have a higher CCC figure than a candy shop because cars typically take longer to sell than candy.
Moreover, some companies, including online retailers like Amazon, have a negative cash conversion cycle. That’s because these companies accept payments before products are shipped. The CCC formula takes both the payment and the product inventory into account, resulting in a negative value for companies like Amazon.
Other companies that do business both online and offline (like Walmart) can have volatile CCC figures that vary wildly based on their ratio of online sales to brick-and-mortar sales.
Although a low CCC is typically preferred, some businesses’ CCC may be high. This is especially true for companies that focus on credit sales and have long-lasting payment terms. After all, turning their average inventory into cash could take years for these companies.
Why businesses should know their cash conversion cycle
Your CCC gives you insight into exactly how long it takes to turn your inventory into liquid cash and helps you manage your business’s cash flow. That’s important because it could play a role in how much inventory you buy when replenishing your shelves.
Moreover, your CCC tells you how long it will take for the money from your current inventory to roll in. As such, you have more information, resulting in a more effective budgeting and accounting process.
The cash conversion cycle formula and how to calculate it
The CCC formula is as follows:
CCC = DIO + DSO - DPO
- CCC is the cash conversion cycle value.
- DIO represents days inventory outstanding.
- DSO represents days sales outstanding.
- DPO represents days payable outstanding.
You’ll need multiple items from your company’s financial statements to calculate your CCC, including:
- Revenue and cost of goods sold (COGS) from the income statement
- Beginning and ending accounts receivable (AR) for the time period
- Beginning and ending accounts payable (AP) for the time period
- Number of days in the time period
Start by calculating your DIO using the formula below:
DIO = (Average inventory / COGS) / 365 days
For your average inventory, add your beginning inventory to your ending inventory and divide the number by 2.
Next, calculate your DSO using the following formula:
DSO = Average accounts receivable / Revenue per day
Average your accounts receivable by adding your beginning and ending AR balances together and dividing the total by 2. Also, average your revenue by dividing your total revenue for the period by the number of days in the period.
Finally, calculate your DPO using the formula below:
DPO = Average accounts payable / COGS per day
Average your accounts payable by adding your starting and ending AP balances and dividing the result by 2. Also, average your COGS by dividing your total COGS for the period by the number of days in the period.
Now that you have all of the input values for the CCC equation, use the equation at the beginning of this section to calculate your CCC.
How to interpret the results of your cash conversion cycle calculation
Your company’s cash conversion cycle tells you quite a bit about your operational efficiency. Here are a few tips to help you interpret your CCC:
- Lower CCC: If your cash conversion cycle is lower than the average for your industry, you’re in good shape. It means your company takes less time to turn its inventory into cash than your competitors do. It also means you have less reliance on outside funding to keep the ship afloat.
- Higher CCC: If your cash conversion cycle is higher than the average for your industry, you may want to work to optimize your operational efficiency. This means it takes your company longer to turn its inventory into cash and increases your reliance on outside funding. If you’re a small business, a higher CCC could even be a sign of coming insolvency.
Keep in mind that average cash conversion cycles vary wildly from one industry to another. For the best interpretation for your business, be sure to compare your CCC with others in the same industry.
How can Ramp help manage your cash flow?
Ramp offers a state-of-the-art money management platform that will help you easily track your dollars through the liquidity cycle every step of the way. Track your expenses, easily spot inefficiencies in your operational processes, and take control of your corporate finances with tools like:
- Sales-based underwriting: Get access to the capital you need based on your sales history with sales-based underwriting.
- Financial forecasting: Take advantage of financial forecasting tools to make sure no dark clouds are on the horizon.
- E-commerce cash flow management: Manage your e-commerce cash flow with the click of a button.
Take our interactive demo today.