Cash Conversion Cycle: What Is It, How to Calculate, and Improve It

Introduction

The biggest challenge most businesses often face especially in the dynamic economic conditions are related to cash flow. A lack of cash flow stifles growth and can even lead to business failure.Cash conversion cycle (CCC) is a key metric that organizations need to pay attention to if they aim to improve their company’s financial health and cash flow. At its core, the CCC is a measure of a company’s operational efficiency. By managing the CCC effectively, companies can optimize their working capital and improve their overall financial performance.

In this blog post, we will cover the cash conversion cycle in detail, including its formula and calculation. We will also provide real-world examples of how the CCC is used in different industries, and strategies for improving your company’s CCC. So, let’s dive in.

What is Cash Conversion Cycle (CCC)?

The cash conversion cycle (CCC) also known as the cash cycle measures the length of time it takes for a company to convert its production and sales investments into cash. This metric aids businesses in improving cash flow and profitability by expediting inventory turnover. 

CCC is a critical measure of a company’s financial performance, and is used by businesses of all sizes to track how quickly they are able to sell their inventory, collect cash from customers, and pay their suppliers

How to Calculate the Cash Conversion Cycle?

Are you wondering how to calculate the cash conversion cycle (CCC) for your business? Understanding the calculation and the cash conversion cycle formula can help you gain valuable insights into how efficiently your company is managing its working capital and generating cash flow from sales.

The CCC covers three stages of a company’s sales cycle – current inventory sales, cash collection from the current sales, and payables for outsourced goods and services. CCC can be calculated using three working capital metrics, and each of these metrics holds valuable insights into what is happening within the business.

The three metrics are:

• Days Inventory Outstanding (DIO)
  Days Inventory Outstanding measures the average number of days it takes for a company to sell its inventory. It indicates how efficiently a company is managing its inventory and turning its assets into revenue. Essentially, DIO measures how quickly a company is able to convert its inventory into sales.
  DIO = (Average Inventory/Cost of Goods Sold) X Number of Days
  
• Days Payable Outstanding (DPO)
  Days Payable Outstanding is a financial metric that measures the average number of days it takes for a company to pay its invoices from trade creditors or suppliers. This metric is crucial for evaluating a company’s cash flow management and assessing its ability to meet its financial obligations. Essentially, DPO indicates how long a company takes to pay its suppliers and manage its working capital effectively.
  DPO = (Accounts Payable/Cost of Goods Sold) X Number of Days
  

Cash Conversion Cycle Formula

The formula for calculating the cash conversion cycle (CCC) is: 

Cash Conversion Cycle = DIO + DSO – DPO

Where DIO stands for Days inventory outstanding, DSO stands for Days sales outstanding, DPO stands for Days payable outstanding.

Cash Conversion Cycle Example

Let’s take an example to simplify the process of calculating the cash conversion cycle. Consider a company called ABC Inc., which operates in the bicycle manufacturing industry and aims to calculate its cash conversion cycle. To begin, the company must determine its days inventory outstanding (DIO), days sales outstanding (DSO), and days payable outstanding (DPO).

DIO: The company’s DIO can be calculated by dividing the average inventory by the cost of goods sold (COGS) and multiplying by the number of days in the period. Suppose ABC Inc. has an average inventory of $500,000 and COGS of $3,000,000 for the year, and the year has 365 days. Then, the DIO can be calculated as follows: DIO = (500,000 / 3,000,000) x 365 = 60.83 days.

DSO: The company’s DSO can be calculated by dividing the accounts receivable by the total credit sales and multiplying by the number of days in the period. Suppose ABC Inc. has accounts receivable of $800,000 and total credit sales of $5,000,000 for the year. Then, the DSO can be calculated as follows: DSO = (800,000 / 5,000,000) x 365 = 58.4 days.

DPO: The company’s DPO can be calculated by dividing the accounts payable by the COGS and multiplying by the number of days in the period. Suppose ABC Inc. has accounts payable of $400,000 and COGS of $3,000,000 for the year. Then, the DPO can be calculated as follows: DPO = (400,000 / 3,000,000) x 365 = 48.67 days.

Now that we have calculated the DIO, DSO, and DPO, we can use the CCC formula to determine the company’s cash conversion cycle. Substituting the values we calculated, we get: 

CCC = 60.83 + 58.4 – 48.67 = 70.56 days. 

Therefore, the cash conversion cycle of ABC Inc. is 70.56 days.

Why Is the Cash Conversion Cycle Important to a Business?

Now that we have understood the formula and calculation for the cash conversion cycle, let’s dive deeper into why it’s important for your business and how it can impact your financial health.

The cash conversion cycle helps manage the inventory. If not managed well, a company will either be short on supply or have too much of it, increasing storage costs. Apart from the inventory management and cash flow efficiencies, CCC also assists finance leaders in: 

1. Determining the financial health of the company 

The CCC is often used by key stakeholders to assess a company’s financial health and liquidity. A lower CCC indicates that a company is able to convert its inventory and receivables into cash quickly, which can improve its ability to meet its financial obligations and pay back business loans.

2. Improving trade credit terms with vendors

Vendors often look at a company’s CCC when deciding whether to offer trade credit. A lower CCC indicates that a company has healthy liquidity and is more likely to pay its bills on time. This can improve a company’s chances of getting better credit terms from vendors.

3. Gaining easy access to capital and loans

A lower CCC can also improve a company’s chances of getting approved for business loans. This is because a lower CCC indicates that a company has a healthy cash flow cycle and is better able to pay back its loans. This can add a sense of security for lenders and increasing approval prospects.

Cash Conversion Cycle Interpretation: What is a Good Cash Conversion Cycle?

When analyzing your cash conversion cycle, keep in mind that it depends on the industry and business nature; there is no one-size-fits-all answer. For instance, industries like fast-moving consumer goods (FMCG) and e-commerce often have an immediate cash conversion cycle, whereas heavy machinery manufacturing and construction typically experience a longer period. 

Generally, a lower CCC is considered a good cash conversion cycle, but the appropriate target CCC varies by industry. For example, retailers typically have a shorter CCC than manufacturers because they have a faster inventory turnover rate.

In some cases, even a negative cash conversion cycle may be desirable. A negative cash conversion cycle denotes that the company is able to collect payment from customers before it has to pay its suppliers. In short organizations with a negative cash conversion cycle have a shorter operating cycle as compared to the cash cycle. This can be advantageous because the company has a positive cash flow without having to use its own capital. However, negative CCCs are rare and may not be sustainable in the long term.

A high CCC can indicate that a company is having difficulty managing its working capital. This can result in a short-term cash flow problem, which can lead to liquidity issues if not addressed. A high CCC may also suggest that the company is inefficient in managing its inventory levels, collecting payments from customers, or paying its suppliers.

A simple way to understand the trajectory of a cash conversion cycle is using graphical interpretation, the downward and upward movement. If the CCC is in a declining trend, it denotes a positive sign, and if you observe an upward trend, it means potential inefficiencies in your order-to-cash processes.

In short, CCC is a valuable metric, but it doesn’t have a definitive good or bad score. Assess its significance within your company and its unique requirements. Additionally, monitoring cash management efficiency is the initial step to unlock your most cost-effective capital source. With understanding in hand, you can develop a plan for further improvement.

How to Improve Your Cash Conversion Cycle?

To optimize your CCC, organizations need to focus on reducing DIO and DSO while increasing DPO. This involves selling inventory faster, collecting payments sooner, and extending bill payment periods. However, organizations need to remember that shortening collection cycles is not the ultimate goal; the key is to prevent customers from falling too far behind on their payments. By being proactive and preventing delinquency, businesses can improve cash flow and maintain control over accounts receivable collection, crucial for running business efficiently.

We all know that merely sending an invoice and expecting timely payments may not always be realistic. That’s why it’s important to take preventive steps to avoid delinquency from the outset. By working to keep customers from becoming significantly past due, organizations can reduce overall cycle times and ensure a consistent cash flow. Here are some key tips to help improve the cash conversion cycle:

• Better payables management: Managing payables such as supplier payment terms is the key to controlling working capital. You can see positive trends in your CCC if you leverage and consolidate your spending by increasing supplier collaboration and extending payment terms.
• Prioritize inventory management: Poor inventory management could lead to lower sales due to the inability to service the placed orders. Thus, inventory management should be prioritized alongside sales, profit, and payment data of the customers. Development of new relationships with customers and clients can also improve inventory management.
• Empower and enable customers to pay with ease: To improve your cash conversion cycle, understand why customers delay invoice payments. Offer solutions to resolve their underlying invoice issues and disputes to reduce the risk of overdue invoices. Categorizing and prioritizing customers by size and risk profile can also be beneficial.
• Ensure consistent communication: Maintain consistent follow-ups through emails and phone calls. Utilize all provided contact information, including office phone, mobile number, email address, and supervisor’s details. If there’s no response within 24 hours to a voicemail or email, consider making another call or escalating the matter to the contact’s supervisor.
• Have a clear credit and payment policy: Be clear with your clients and clearly convey your payment expectations and collection procedures to them. Encourage open communication and have clients explain their payment processing procedures to work together in ensuring timely payments. This collaborative approach fosters a smoother payment process and strengthens client relationships.
• Take proactive measures: Be proactive and anticipate customer needs. For example, if a customer requires an additional bill copy, send it in advance without waiting to be asked. Maximize your collection management software by configuring it to automatically send transaction documents, such as invoices or proofs of delivery. This proactive approach improves the customer experience and streamlines the collection process, enhancing efficiency and satisfaction.
• Call early, call often: When significant dollars are involved, calling before an invoice is past-due is an effective strategy. Making a list of those who are likely to pay late and flag their transactions for a proactive call. If an invoice goes overdue, make a call or send an email within days of the event. This approach helps in early resolution and ensures timely payments, contributing to better cash flow management.
• Leverage automation: Harness the power of automation to optimize your cash conversion cycle. The efficiency of your cash conversion process directly influences working capital, cash flow, and overall financial performance. In today’s competitive landscape, relying on outdated, manual procedures can hinder growth and efficiency.

How Automation Can Revolutionize Business’s Cash Conversion Cycle?

If your business is not leveraging automation, it’s time to consider the transformative potential it can bring to your CCC. By automating critical processes such as credit management and collections, businesses can streamline their workflows, reduce manual errors, and increase efficiency. Here are some key benefits of automating these processes:

1. Enhanced efficiency: Automation allows businesses to prioritize customers based on their credit risk and payment behavior, enabling collectors to focus their efforts on the most critical accounts. This streamlined approach to collections enables a more efficient use of time and resources, leading to faster revenue realization and shorter cash conversion cycles. 
2. Improved accuracy: Automated credit management systems use advanced analytics to provide businesses with real-time credit risk visibility. This enables decision-makers to make more informed credit decisions, reducing the risk of bad debt and improving overall accuracy in the credit management process. Taking analytics based credit decisions enables organizations to reduce non payment risks and improve cash conversion in the long term. 
3. Faster dispute resolution: Automated dispute management systems enable businesses to quickly identify and resolve disputes, reducing the time it takes to resolve payment issues and improving overall cash flow.
4. Enhanced customer experience: Automated collections systems enable businesses to engage with customers in a more personalized and timely manner and design personalized payment options for them. This can lead to improved customer satisfaction and loyalty, as well as faster payment times.
5. Data-driven insights: Automated systems provide businesses with real-time insights into their collections process, enabling decision-makers to analyze performance, identify trends, and make data-driven decisions that improve overall cash conversion cycle.

How HighRadius Can Help?

Effortlessly optimizing the cash conversion cycle (CCC) ensures a smooth flow of funds and finely tuned working capital for organizations. At the core of CCC optimization lies automation, which transforms complex processes such as setting customer credit limits, inventory tracking, and collections management. By embracing automation, businesses reduce manual efforts and errors, accelerating revenue realization and enhancing cash flow. Leveraging AI and RPA technology, businesses can streamline the order-to-cash process, gaining real-time insights into collection performance.

HighRadius offers AI-driven solutions that redefine CCC optimization. The HighRadius Order to Cash Suite automates credit management, collections, invoicing, cash application and dispute resolution, leading to faster revenue realization and improved cash flow. Designed to streamline workflows and enhance the customer journey, HighRadius’s O2C solutions drive financial performance, reducing DSO by an impressive 20%.

But HighRadius goes beyond automation; it empowers organizations to make data-driven decisions through AI-powered analysis. By seamlessly integrating workflows for AR teams and automating routine tasks, resources are freed to focus on high-yield endeavors, resulting in a remarkable 30% increase in productivity. With HighRadius O2C Suite, the journey towards CCC optimization is not just a destination but a testament to innovation and success.

FAQs 

1. What is the cash conversion ratio?

The cash conversion ratio is a financial metric used to assess a company’s ability to convert its net income into cash flow. It measures the proportion of cash generated from operations relative to net income, indicating operational efficiency in converting profits into cash. 

2. What are the factors affecting the cash conversion cycle?

The factors affecting the cash conversion cycle (CCC) include inventory management, accounts receivable, and accounts payable. A longer inventory holding period, longer payment terms from customers, and longer payment terms to suppliers can all contribute to a longer CCC.

3. What is the optimal cash conversion cycle?

The optimal cash conversion cycle (CCC) varies by industry and business nature. Generally, a lower CCC is considered better as it indicates efficient management of working capital. However, the appropriate target CCC varies by industry, and businesses should aim to improve their CCC over time.

4. What is a negative cash conversion cycle?

A negative cash conversion cycle occurs when a company’s accounts payable period is longer than its accounts receivable and inventory turnover periods combined. This results in cash being received from sales before payments are due, improving liquidity and operational efficiency.

5. What is a good cash conversion cycle?

A shorter cash conversion cycle is considered a good cash conversion cycle and indicates efficient management of receivables, inventory, and payables, which improves liquidity and operational performance. However, what constitutes a “good” cycle varies by industry and company objectives.

6. What is the cash cycle?

The cash cycle, or cash conversion cycle, is the time it takes for a company to convert its investments in inventory into cash flow from sales. It’s measured by adding days inventory outstanding to days sales outstanding and subtracting days payable outstanding.

7. What is cash flow conversion?

Cash flow conversion refers to the process of turning sales revenue into cash receipts. It measures how effectively a company converts its sales into actual cash inflows by managing receivables, payables, and inventory efficiently. It is crucial for assessing liquidity and operational efficiency.

8. What is the cash to cash cycle?

Cash to cash cycle, also known as the cash conversion cycle, measures the time it takes for a company to convert its investments in inventory and other resources into cash flow from sales. It involves managing accounts receivable, inventory, and accounts payable effectively to optimize liquidity.

9. What is the cash flow cycle?

The cash flow cycle depicts the movement of cash in and out of a business over a specific period. It begins with cash inflows from sales, investments, or financing, followed by outflows for expenses, investments, and debt repayment, influencing a company’s liquidity and financial health.