Understanding and Improving the Cash Conversion Cycle
There are many metrics and numbers that businesses should be tracking to ensure they’re growing and maturing as intended, including a critical one known as the cash conversion cycle.
It’s an often-underrated consideration that can reveal vital organizational issues and provide clear ways to improve. So what do you need to know about the cash conversion cycle?
Let’s take a closer look.
Defining Cash Conversion Cycle
Sometimes known as the net operating cycle, the cash conversion cycle (CCC, for short) refers to the time (usually in days or weeks) between when a company invests in inventory and supporting expenses and when that money is recouped through sales and billing.
This is important for a variety of reasons.
First, it’s an excellent sign of your business’s efficiency and whether you’re making a good amount of sales relative to your inventory.
Money tied up in inventory is also vital to the operations of any company, which means it’s important to keep too much cash from ending up temporarily “stuck” when it might be needed for payroll or other expenses.
Conversely, a too-short CCC could mean you’re leaving sales on the table by not having adequate inventory on hand.
Calculating Cash Conversion Cycle
The formula for the cash conversion cycle is fairly simple. It’s derived by taking the days of inventory your company has outstanding (DIO), adding the Days of Sales Outstanding (DSO), then subtracting the Days of Payable Outstanding.
Days of Inventory
DIO is calculated by dividing the average inventory level over a given period by the cost of those goods. This number is then multiplied by 365 to provide the number of days it takes the company to fully turn over its inventory.
Days of Sales Outstanding
DSO, on the other hand, measures how long it takes to collect receivables and is found by dividing the average accounts receivable by total credit sales in a period, once again multiplied by 365. This represents the amount of time it generally takes to collect invoices.
Days of Payable Outstanding
Finally, DPO is a metric of how long your company takes to pay back your creditors and suppliers. Find it by dividing average accounts payable by the cost of goods sold and multiplying by 365.
As you can see, tweaks to your business will affect these numbers in various ways. For example, CCC can be lowered by selling faster (decreasing your DIO) or collecting bills more efficiently (decreasing DSO) and raised by doing the opposite or increasing the amount you owe to suppliers.
Common Challenges with the Cash Conversion Cycle
Unfortunately, understanding how to manage your cash conversion cycle is often a lot easier than actually doing it. These challenges primarily come when trying to:
- Manage inventory levels
- Speed up payments and accounts receivable
- Ensure accounts payable are satisfied on time.
For example, putting an excess of capital into inventory will raise your DIO, raising your CCC, all else being equal. This same effect would result from a few large customers paying their invoices a bit later or your company owing more to its suppliers.
Improving Cash Conversion Cycle
While some business owners may not be pleased with what they find when they examine their CCC, the good news is there are plenty of ways to improve it. Here are a few of the most common.
Improve Inventory Management
Use data on your purchases and sales to examine whether your inventory is managed as efficiently as possible. If products sit in your warehouse or other storage for a long time without being sold, it may be worth tweaking how much you have on hand to free up some extra cash.
Streamline Accounts Receivable
Examine your invoicing process, and see where improvements can be made. These include:
- Automatic billing and reminders
- Optimized invoices
- More and easier ways to pay
- Putting more dedicated help toward collecting what’s due
Optimize Accounts Payable
Ensuring bills get paid on time will also lower CCC by lowering DPO. Work with suppliers and creditors to see if you can find an accounts payable solution that helps both sides, whether by setting up automated payments, shifting invoice dates, or another way to speed up payables.
All these techniques and many more can be accomplished far easier with modern technology.
These include comprehensive accounting and financial software and other advancements that shave important time and redundant steps from the business process.
Do You Still Have Questions?
For the reasons above and many others, it’s vital for any successful business to know its cash conversion cycle and work to optimize it as much as possible.
Lower CCCs keep your business agile and are signs of good relationships with suppliers and clients alike, with an efficient cash flow process helping everyone involved.
Whether you’re a seasoned business expert or just getting your company on its feet, it can be a lot of work not just managing the daily issues that affect the cash conversion cycle but also plotting strategy for the future.
Fortunately, PlotPath can help. Our experienced financial professionals have helped optimize countless businesses with tweaks small and large that put them on a better path forward. With our help, you can put your focus back where it matters, which is doing the work that makes your business worth it. Contact us today to learn more about what we can do for you and your organization.