Whenever you purchase inventory from suppliers, you do so with the expectation that you’ll later convert it to revenue.
Whether you’re buying pre-made goods and retailing them as you are purchasing components and materials to build your own products, the idea at the end of it all is to sell those goods, turning them into revenue.
But how long does that process actually take?
Cash conversion cycle, which often goes under the acronym CC, is a financial metric that measures exactly that: the length of time it takes your business to turn inventory and other resources into cash flow.
In this article, we’ll be diving into all things cash conversion cycle.
We’ll explain what it is, why it's important for business leaders to be aware of, how to calculate it, and strategies to implement to shorten yours.
What is the cash conversion cycle?
The cash conversion cycle (CCC) is a financial metric. It measures the time it takes for a business to convert the cash it pays for inventory and other resources into cash flow from sales.
Generally speaking, shorter CCCs are better, indicating that a company can quickly turn its investments into cash, improving liquidity and financial health.
The cash conversion cycle metric consists of three core components:
- Days Inventory Outstanding (DIO)
- Days Sales Outstanding (DSO)
- Days Payable Outstanding (DPO)
To get a better understanding of how CCC works, let’s explore these three components.
The CCC consists of three main components:
1. Days Inventory Outstanding (DIO)
Days Investory Oustanding is a measure of the average number of days a business takes to sell its inventory. It’s a reflection of the efficiency of the company’s inventory management.
A lower DIO suggests a faster turnover of inventory.
To calculate it, you take your average inventory value, divide it by your cost of goods sold for the same period, and multiply that by 365.
2. Days Sales Outstanding (DSO)
Days Sales Outstanding calculates the average number of days it takes for a business to collect payment after it makes sales. It’s a reflection of the efficiency of the company’s credit and collections process.
A lower DSO indicates that the company collects its receivables more quickly, having a positive impact on cash flow.
To calculate it, you take your average accounts receivable, divide it by total credit sales, and multiply that by 365.
3. Days Payable Outstanding (DPO)
Days Payable Outstanding is the opposite of DSO. It calculates the average number of days a business takes to pay its suppliers. It's a reflection of how long a company holds onto its cash before settling its financial obligations.
A higher DPO indicates the company takes longer to pay its suppliers, which can be effective for improving short-term liquidity as long as it doesn’t have a long-term negative effect on vendor relationships.
To calculate, you take your average accounts payable, divide it by your costs of goods sold, and multiply that by 365.
The impact of cash conversion cycles on liquidity and financial health
CCC is an important measure of an organization's liquidity and overall operational efficiency.
A shooter CC implies that the business has less capital tied up in the production and sales process, meaning it has more free cash available for other uses, such as long-term investments or paying down debt obligations.
Conversely, a longer CCC means that the business has its cash tied up in operations for long time periods, which can make it harder for a company to cover its short-term liabilities and can potentially lead to cash flow problems.
Cash conversion cycle formula
Here’s how to calculate your own cash conversion cycle.
First, you’ll need to pull together the three figures discussed above. Here’s a quick recap:
Once you’ve got these three figures, the formula to calculate CCC is:
CCC=DIO+DSO−DPO
What is a good cash conversion cycle?
This depends entirely on your industry.
Some sources indicate that the most efficient enterprises are operating at around 30 days, with the median calculating a CCC of 45 days.
This is a good benchmark, but the definition of a “good” cash conversion cycle is going to vary significantly by industry. In industries where the production of the product in question takes months (like vehicles and heavy machinery), achieving a CCC of 30 days is impossible.
The best approach here is to calculate your own CCC using the above mentioned formula, then work on improving your metric. We’ll discuss strategies on how to achieve that shortly.
What does a negative cash conversion cycle mean?
A negative cash conversion cycle means a company is able to collect money from sales before it has to pay its suppliers.
This means that DPO (days payable outstanding) is greater than the sum of DIO (days inventory outstanding) and DSO (days sales outstanding).
This is a highly favorable position to be in. It means the company is effectively using its suppliers’ capital to finance its own operations. It's an indication of excellent working capital management, strong liquidity, and a highly efficient cash flow cycle.
Common challenges related to the cash conversion cycle
While big brands like Amazon are often able to achieve very low or even negative cash conversion cycles, it’s a lot harder for small and medium-sized businesses.
Here are some of the biggest challenges that SMBs face in that respect.
- Excess inventory. Small businesses often struggle with overstocking, especially when they are new and have yet to establish a baseline for inventory turnover. This leads to a higher DIO.
- Slow customer payments. Many SMBs struggle to receive payments quickly from their customers, increasing DSO.
- Limited negotiation powers. Being small, SMBs have less leverage to negotiate more favorable payment terms with their vendors, leading to shorter DPOs.
- Inconsistent cash flow forecasting. Many small businesses lack accurate cash flow forecasting tools, which makes it hard for them to manage liquidity effectively or to plan for cash shortages.
- Dependence on manual processes. It’s not uncommon for SMBs to be overly reliant on manual processes rather than taking advantage of automated systems for invoicing, payments, and inventory management, all of which can have a positive impact on CCC.
How to shorten your cash conversion cycle
Reducing your CCC can help you free up cash, improve liquidity, and reduce financing costs.
Here are some best practices to shorten your own cash conversion cycle.
1. Improve inventory management (to reduce DIO)
Focus on reducing your days inventory outstanding metric by:
- Optimizing inventory levels with strategies like just-in-time (JIT) inventory management.
- Implementing demand forecasting to better match inventory levels with customer demand.
- Increasing inventory turnover by focusing on selling slower-moving products or discontinuing underperforming items.
- Negotiating with suppliers to shorten lead teams and ensure quicker restocking.
2. Streamline accounts receivable processes (to reduce DSO)
Work to reduce your days sales outstanding figure by paying attention to your accounts receivable process.
You can:
- Enforce shorter payment terms to receive cash from customers faster.
- Automate invoicing and payment collection to ensure invoices are sent out right away.
- Run credit checks on new clients to ensure they have a history of timely payments.
- Offer multiple payment methods to give customers more options and encourage faster payments.
3. Extend accounts payable (to increase DPO)
Finally, to increase your days payable outstanding, you can work on extending accounts payable by:
- Negotiating longer payment terms with suppliers, allowing you to hold onto your cash for longer.
- Leveraging supplier discounts more cautiously, balancing the desire to pay early and receive a discount against the company’s cash flow needs.
- Using batch payments to suppliers rather than paying invoices individually, maximizing the use of cash.
- Considering the use of trade credit as a way to receive inventory and potentially even sell it before your invoice is due.
Master cash flow management
For small and medium-sized organizations, managing a cash conversion cycle is critical for maintaining healthy cash flow and ensuring liquidity.
Modern tools like BILL, our financial operations platform, can play an important role in reducing CCC and improving cash flow management.
With BILL, you can:
- Automate invoice and payment collection to help reduce your days sales outstanding
- Offer multiple payment methods, such as ACH, credit cards, and wire transfers, to help receive cash from customers faster
- Implement accounts payable automation to more effectively manage vendor payments, increasing your days payable outstanding
Discover BILL’s huge range of powerful features for better cash flow management today.
