As a business owner, you have a lot of financial matters to balance. Maintaining financial health, stability, and growth involves calculating many different metrics to make sure your business is on the right track to hit the goals you’ve set for yourself.
An important metric to track within this process is your business’s cash conversion cycle. This number can help you understand how well you’re managing the process of buying inventory, collecting payments from customers or clients, and then paying your vendors for that inventory.
Getting a better grasp of the cash conversion cycle and how it demonstrates the financial health of your business can help you stay on top of cash flow and inventory management, among many other important facets of your operations.
Let’s explore the cash conversion cycle, how to calculate it, what a good cash conversion cycle looks like, and why this metric matters to your business.
The cash conversion cycle (CCC) is a metric that indicates how fast a company is able to convert its initial capital investment into cash. This cash flow metric can tell you how efficiently your business uses its short-term assets and liabilities to maintain liquidity.
In other words, the cash conversion cycle tells you how much time is between paying for inventory and/or supplies and getting paid by customers or clients.
Typically, you only calculate your CCC if you run a business that regularly handles inventory or materials, such as a retail business or construction company.
You may also know this metric by its other names—cash cycle, cash-to-cash cycle, or net operating cycle. However, it shouldn’t be confused with the operating cycle, which is a different metric altogether.
Operating cycle refers to the total number of days between when you purchase inventory and when customers pay for the inventory. In contrast, net operating cycle (aka CCC) is the length of time between actually paying for the inventory and collecting the payments from customers who’ve purchased inventory. This timeframe can include net-terms with you and vendors or your customers.
You must use a few different operational ratios, including accounts receivable, accounts payable, and inventory turnover, to find the numbers you need to input into the CCC formula. You can find these elements on different financial statements, such as your balance sheets and income statements:
You must also determine the period for which you want to calculate the CCC, such as a whole fiscal year or a quarter. Use the number of days in the period you’re measuring, such as 365 days for a year or 90 days for a quarter. Make sure that you use the same period for every step to get the most accurate CCC calculation.
Here are the 3 elements that make up the CCC formula and how to calculate them:
Days Inventory Outstanding (DIO): This number is the average time it takes to convert inventory into goods you then sell. Find the DIO by taking your average inventory for the period you’re measuring, divide it by the COGS, and then multiply by the number of days in the period you’re measuring.
Days Sales Outstanding (DSO): This is the average number of days it takes to collect AR over the same period. First, divide your AR by net credit sales. Then, multiply that by the number of days in the period to find the DSO.
Days Payable Outstanding (DPO): This is the average number of days it takes your business to order from vendors and then pay your AP to them. Take the ending AP and divide it by COGS to get the DPO.
Or, you can calculate it with this formula:
Now that you have all the parts, you can use this formula to determine your CCC for a given period:
Companies with a low CCC typically have higher liquidity, meaning they have more cash on hand, which is a sign of great operational and financial management. When a CCC is high, that means a company is taking too long to convert inventory—that they’ve bought on credit that is to be paid back when customers start purchasing goods—into usable cash.
That means the goal is to have as low of a CCC as possible to ensure the best possible financial health of your business. Having a negative CCC is even better because it means your cash isn’t tied up for long at all. In fact, there’s no time spent waiting to get paid.
However, it’s important to note that online retail businesses are more likely than others to have a negative CCC. That’s because these businesses typically use drop shipping, meaning they don’t hold inventory and don’t have to pay for inventory until customers pay them first. This process also helps e-commerce stores manage a lot of the working capital problems that come with traditional brick-and-mortar retailers.
Here are some elements that make up a good CCC:
Keeping an eye on your cash conversion cycle is important to growing and sustaining your business. Investors, lenders, and other financial resources typically review a company’s CCC to determine its financial health and its liquidity. And the more liquid a company is, the more likely it is to pay back loans and grow investments. That makes for a great financing opportunity for lenders and investors.
You also can use your CCC to compare your business’s financial state to that of your competitors. It can give you a better idea of where you stand in terms of business practices and market share.
When your CCC is solid, it often means that you are managing your business operations, including inventory acquisition, turnover, and client or customer payments, well. That can make you feel more confident about the state of your business.