How to calculate and interpret your cash conversion cycle

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.

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One such tool is known as the cash conversion cycle (CCC), cash flow conversion cycle (CFCC), or net operating cycle (NOC).

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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.

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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.

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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.

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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.

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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.

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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.

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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 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.

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The ​​cash conversion cycle formula and how to calculate it

The CCC formula is as follows:

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CCC = DIO + DSO - DPO

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Where:

• 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:

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DIO = (Average inventory / COGS) / 365 days

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For your average inventory, add your beginning inventory to your ending inventory and divide the number by 2.

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Next, calculate your DSO using the following formula:

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DSO = Average accounts receivable / Revenue per day

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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.

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Finally, calculate your DPO using the formula below:

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DPO = Average accounts payable / COGS per day

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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.

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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.

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What is an example of a cash conversion cycle?

Let's go through an example using the Cash Conversion Cycle (CCC) formula:

Assumptions:

• COGS (Cost of Goods Sold): $400,000
• Revenue: $700,000
• Beginning Inventory: $80,000
• Ending Inventory: $60,000
• Beginning Accounts Receivable (AR): $100,000
• Ending Accounts Receivable (AR): $120,000
• Beginning Accounts Payable (AP): $50,000
• Ending Accounts Payable (AP): $70,000
• Period: 365 days (1 year)

1. Calculate DIO (Days Inventory Outstanding)

DIO measures how long it takes on average to turn inventory into sales.

• Average Inventory = (Beginning Inventory + Ending Inventory) / 2
  (80,000 + 60,000) / 2 = 70,000
• DIO = (Average Inventory / COGS) × 365
  (70,000 / 400,000) × 365 = 63.9 days

2. Calculate DSO (Days Sales Outstanding)

DSO measures how long it takes to collect payment from customers.

• Average AR = (Beginning AR + Ending AR) / 2
  (100,000 + 120,000) / 2 = 110,000
• Revenue per day = Revenue / 365
  700,000 / 365 = 1,917.8
• DSO = Average AR / Revenue per day
  110,000 / 1,917.8 = 57.4 days

3. Calculate DPO (Days Payable Outstanding)

DPO measures how long it takes to pay suppliers.

• Average AP = (Beginning AP + Ending AP) / 2
  (50,000 + 70,000) / 2 = 60,000
• COGS per day = COGS / 365
  400,000 / 365 = 1,095.9
• DPO = Average AP / COGS per day
  60,000 / 1,095.9 = 54.8 days

4. Calculate CCC (Cash Conversion Cycle)

Now using the CCC formula:

CCC = DIO + DSO - DPO
CCC = 63.9 + 57.4 - 54.8
CCC = 66.5 days

Interpretation:

The cash conversion cycle is 66.5 days, meaning the company takes about 67 days to convert its investments in inventory and other resources into cash flows from sales.

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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 due to differences in inventory management, payment terms, and customer payment behavior. For the best interpretation for your business, be sure to compare your CCC with others in the same industry. Here are some general benchmarks for CCC across major industries:

1. Retail Industry

• Average CCC: 60 to 90 days
• Details: Retailers typically hold inventory for extended periods but often receive customer payments quickly. However, due to competitive payment terms from suppliers, DPO can vary. For example, large retailers like Walmart or Amazon have very low CCC because of fast turnover and extended payment terms.

2. Technology and Electronics

• Average CCC: 35 to 55 days
• Details: Tech companies, particularly hardware manufacturers, generally have shorter CCCs. This is because of fast inventory turnover and short collection periods from customers. However, companies with longer production cycles (like semiconductors) may have longer CCCs.

3. Automotive Industry

• Average CCC: 60 to 100 days
• Details: The automotive industry generally has long CCCs due to the extended time needed for production and sales of vehicles. Manufacturers often hold inventory for long periods and might have extended DSO periods with dealers. Suppliers, on the other hand, often have favorable payment terms (DPO).

4. Manufacturing Industry

• Average CCC: 50 to 100 days
• Details: Manufacturers often deal with raw materials and production processes that take time, resulting in a high DIO. They may also have extended terms for accounts receivable, though DPO can be negotiated for longer periods.

5. Food and Beverage Industry

• Average CCC: 20 to 50 days
• Details: The CCC in the food and beverage industry is relatively short due to quick inventory turnover, as products are perishable. However, smaller businesses may have longer CCCs compared to larger companies that can negotiate better payment terms from suppliers.

6. Pharmaceuticals

• Average CCC: 100 to 150 days
• Details: The pharmaceutical industry typically has a long CCC due to significant research and development, long inventory periods, and stringent regulations. The time from production to sale is extended, though larger companies may negotiate favorable DPO terms.

7. Apparel Industry

• Average CCC: 50 to 90 days
• Details: Apparel companies often have to hold large amounts of inventory for long periods before selling it, especially in fast fashion. However, they usually have favorable payment terms with suppliers (high DPO), which can offset the CCC.

8. Aerospace & Defense

• Average CCC: 150 to 300 days
• Details: This industry has one of the longest CCCs due to the lengthy manufacturing processes, high DIO, and long periods before receiving payment (DSO). These companies usually operate on large contracts with extended timelines.

9. Consumer Goods

• Average CCC: 40 to 70 days
• Details: Companies in this industry typically have shorter CCCs because of fast-moving goods and the ability to negotiate good payment terms from suppliers (longer DPO).

10. Telecommunications

• Average CCC: 30 to 60 days
• Details: Telecom companies often have relatively short CCCs, with moderate DIO and DSO values. Their large customer bases allow for efficient revenue collection, but they often deal with capital-intensive equipment with longer inventory turnover.

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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.

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