In The Importance of Working Capital and its Connection to Inventory, we dove into what exactly working capital is and how it can be calculated. To recap, working capital is the amount of assets a business has available after all current liabilities have been accounted for. Companies need to have a good understanding of their working capital and working capital ratio, so they can manage assets accordingly.
It is also wise for a company to have a good grasp on its Cash-to-Cash Cycle, or Cash Conversion Cycle (CCC).
What is the Cash-to-Cash Cycle?
Your Cash-to-Cash Cycle, or your Cash Conversion Cycle, measures the efficiency and effectiveness of your company’s management of its working capital. This cycle measures the number of days it takes a company to generate and collect revenue from its inventory assets. In other words, the CCC measures the time it takes a company to purchase its inventory and then collect cash from its sales.
Cash Conversion Cycle Formula
Cash Conversion Cycle = Days Inventory Outstanding (DIO) + Days Sales Outstanding (DSO) – Days Payable Outstanding (DPO)
Let’s do a deeper dive into the other components of the equation.
Days Inventory Outstanding (DIO): The average number of days a company holds its inventory before selling it. The higher the DIO, the slower the inventory turnover is. Slower, or lower, inventory turnover results in a longer CCC which is not good for a business. On the other hand, the shorter the CCC, the better the company is at selling, being paid, and paying suppliers.
Days Sales Outstanding (DSO): The average number of days a company takes to collect cash from its credit sales (accounts receivable).
Days Payable Outstanding (DPO): The average number of days a company takes to pay its suppliers.
The purpose of the Cash Conversion Cycle is for a company to analyze how efficiently it is managing its working capital. But what is the direct connection between the CCC and inventory?
How Inventory Impacts the Cash Conversion Cycle
As noted by The crucial link between inventory and cash conversion cycle: Industry insights: “Inventory management plays a pivotal role in the CCC. Efficient inventory management ensures that the right amount of stock is available to meet customer demand while minimizing excess inventory. This balance is crucial as excessive inventory ties up valuable working capital, increasing carrying costs and reducing cash flow. On the other hand, insufficient inventory can result in lost sales and dissatisfied customers.”
The article goes on to explain: “There is an undeniable link between inventory management and cash conversion cycles across various industries. By optimizing inventory levels, businesses can improve their cash flow, reduce carrying costs, and enhance overall financial performance.”
Now that we know what a vital role inventory plays in the CCC, let’s look at what it means to have a CCC that is positive and whether a CCC can be negative.
As noted by the BDC, cash flow is impacted by three key elements:
- Accounts receivable: The money owed to your company by customers who have received goods or services but haven’t paid for them yet.
- Accounts payable: The money owed by a company to suppliers for goods and services that have been provided but not paid for.
- Inventory: Raw materials or finished goods a company purchases from a supplier and sells to customer. Inventory generates revenue, and when a company buys inventory, this creates account payable and it is sold, this creates accounts receivable.
What is a Good Cash Conversion Cycle?
Keeping these definitions in mind, what does a positive cash conversion cycle mean? In short, it means a slow cash flow. Companies that find themselves in this position may need to get extra financing to support the business so they can pay suppliers in a timelier manner. Alternatively, they can analyze what daily operations are tying up cash.
On the other hand, what does a negative cash conversion cycle mean? Well, as one would expect, opposite to positive CCC, it means quick cash flow. If your CCC calculations produce a negative number, this means cash is moving quickly and you will not have any problem paying supplier invoices. According to the BDC, the greater the negative number, the easier it is to meet financial obligations.
Improving your Cash Conversion Cycle
So, how can a company get a better handle on its CCC numbers? There are three common recommendations.
Reduce average days receivable: This can be achieved by offering discounts to customers who pay early, ask for early payment, be firm with slow paying customers, etc.
Speed up average days inventory: Explore what is selling versus what is taking up space and look to your sales department to help reduce inventory and get rid of what’s not selling.
Extend your average days payable: Extend your credit with suppliers without ruining your relationship with them; this can be achieved by tracking and managing bills.
Our data-intelligence platform at The Owl Solutions can also help you organize and track the data pertinent to your company so you can focus on improving and managing your Cash Conversion Cycle. With the help of our platform, you can say goodbye to manual excel sheets and marvel at having all your supply chain information at your fingertips displayed in a clear and user-friendly way.