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Meaning of Cash Conversion Cycle
Cash Conversion Cycle or CCC is the number of days that a business entity takes to convert its input resources into liquid cash flow. This metric aims to measure how much time a company takes to sell its inventories, collect its receivables and pay off its bills without any delay penalty being charged. Every dollar that is tied up to the process of production till it is recovered as sales are scrutinized to calculate the cash cycle of an entity. A lower number of days are the most desirable when it comes to Cash Conversion Cycle.
Description of Cash Conversion Cycle
A company does not conduct the process of production in cash. The raw material is acquired on credit, also called Accounts Payable. On the other hand, sales on large scales to wholesalers or parties second in line of the chain are conducted on credit basis as well, which is called “Accounts Receivable”. The time taken to receive cash from debtors and pay back the creditors is the element of cash conversion cycle.
After understanding the meaning of cash conversion cycle, let us look at the calculation of the same to gain better understanding.
Cash Conversion Cycle Calculation
The length of a cycle can be measured using the following formula:
CCC = DIO + DPO + DSO Days
DIO = Days Inventory Outstanding
DPO = Days Payables Outstanding (Denoted in Negative)
DSO = Sales Outstanding
Let us see an example of cash conversion cycle to understand it further.
Cash Conversion Cycle Example
Let’s assume a company XYZ runs its production cycle for making automobiles. The cars are stored in their warehouse for a period of 12 days. It takes XYZ 17 days to collect the receivables from the sale of each car and 10 days to pay back the credit to its vendors.
Cash Conversion Cycle of XYZ = 13 + (-10) + 17
CCC = 20 days
By the above example, we understand how cash conversion cycle takes into consideration the time taken to manufacture, sell and collect dues for an inventory.
Cash Conversion Cycle analysis is an important metric because we understand the lock-in period of an investment for the purpose of production. A lot can be told analyzing the cash conversion cycle of a company. Delays in collecting dues, overproduction can result in long cash cycles. As a firm can only pay its bills through cash and not profits, a long cash cycle can lead to several problems, the most extreme being bankruptcy. Lower the number of days, more efficient the company is at using its cash resources.
Negative cash cycles are another occurrence. It simply means that a company doesn’t pay for the material resources even after the sale of the product. Cash conversion cycle scrutinizes only the production to sale efficiency. However, net operating profit is a gauge to measure operational as well as managerial competency.
You can also check out our article on the “Different Types of Variance Analysis”.