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Cash Conversion Cycle

The amount of time it takes a company to convert its investments in inventory to cash

What is the Cash Conversion Cycle?

The Cash Conversion Cycle (CCC) is a metric that shows the amount of time it takes a company to convert its investments in inventory to cash. The cash conversion cycle formula measures the amount of time, in days, it takes for a company to turn its resource inputs into cash. Learn more in CFI’s Financial Analysis Fundamentals Course.

 

Cash Conversion Cycle Diagram & Formula

 

Cash Conversion Cycle Formula

The cash conversion cycle formula is as follows:

 

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

 

What is Days Inventory Outstanding (DIO)?

Days Inventory Outstanding (DIO) is the number of days, on average, it takes a company to turn its inventory into sales. Essentially, DIO is the average number of days that a company holds its inventory before selling it. The formula for days inventory outstanding is as follows:

 

Days Inventory Outstanding (DIO) Formula

 

For example, Company A reported a $1,000 beginning inventory and $3,000 ending inventory for the fiscal year ended 2018 with $40,000 cost of goods sold. The DIO for Company A would be:

 

Days Inventory Outstanding (DIO) Example

 

Therefore, it takes this company approximately 18 days to turn its inventory into sales.

 

What is Days Sales Outstanding (DSO)?

Days Sales Outstanding (DSO) is the number of days, on average, it takes a company to collect its receivables. Therefore, DSO measures the average number of days for a company to collect payment after a sale. The formula for days sales outstanding is as follows:

 

Days Sales Outstanding (DSO) Formula


For example, Company A reported a $4,000 beginning accounts receivable and $6,000 ending accounts receivable for the fiscal year ended 2018 with credit sales of $120,000. The DSO for Company A would be:

 

Days Sales Outstanding (DSO) Example


Therefore, it takes this company approximately 15 days to collect a typical invoice.

 

What is Days Payable Outstanding (DPO)?

Days Payable Outstanding (DPO) is the number of days, on average, it takes a company to pay back its payables. Therefore, DPO measures the average number of days for a company to pay its invoices from trade creditors, i.e., suppliers. The formula for days payable outstanding is as follows:

 

Days Payable Outstanding (DPO) Formula


For example, Company A posted a $1,000 beginning accounts payable and $2,000 ending accounts payable for the fiscal year ended 2018 with $40,000 cost of goods sold. The DSO for Company A would be:

 

Days Payable Outstanding (DPO) Example


Therefore, it takes this company approximately 13 days to pay for its invoices.

 

Learn more in CFI’s Financial Analysis Fundamentals Course.

 

Putting it Together: Cash Conversion Cycle

Recall that the Cash Conversion Cycle Formula = DIO + DSO – DPO. How do we interpret it?

We can break the cash cycle into three distinct parts: (1) DIO, (2) DSO, and (3) DPO. The first part, using days inventory outstanding, measures how long it will take the company to sell its inventory. The second part, using days sales outstanding, measures the amount of time it takes to collect cash from these sales.

The last part, using days payable outstanding, measures the amount of time it takes for the company to pay off its suppliers. Therefore, the cash conversion cycle is a cycle where the company purchases inventory, sells the inventory on credit, and collects the accounts receivable and turn it into cash.

Using the DIO, DSO, and DPO for Company A above, we find that our cash conversion cycle, for Company A, is:

 

CCC = 18.25 + 15.20 – 13.69 = 19.76

 

Therefore, it takes Company A approximately 20 days to turn its initial cash investment in inventory back into cash.

 

Interpreting the Cash Conversion Cycle

The cash conversion cycle formula is aimed at assessing how efficiently a company is managing its working capital. As with other cash flow calculations, the shorter the cash conversion cycle, the better the company is at selling inventories and recovering cash from these sales while paying suppliers.

The cash conversion cycle should be compared to companies operating in the same industry and conducted on a trend. For example, measuring a company’s cash conversion cycle to its cash conversion cycles in the previous years can help with gauging whether its working capital management is deteriorating or improving. In addition, comparing the cash conversion cycle of a company to its competitors can help with determining whether the company’s cash conversion cycle is “normal” compared to industry competitors.

 

Related Readings

CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful:

  • Analysis of Financial Statements
  • Comparable Company Analysis
  • Guide to Financial Modeling
  • Sales and Collection Cycle

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