1. Liquidity Measurement Ratios: Introduction
  2. Liquidity Measurement Ratios: Current Ratio
  3. Liquidity Measurement Ratios: Quick Ratio
  4. Liquidity Measurement Ratios: Cash Ratio
  5. Liquidity Measurement Ratios: Cash Conversion Cycle

By Richard Loth (Contact | Biography)

This liquidity metric expresses the length of time (in days) that a company uses to sell inventory, collect receivables and pay its accounts payable. The cash conversion cycle (CCC) measures the number of days a company's cash is tied up in the the production and sales process of its operations and the benefit it gets from payment terms from its creditors. The shorter this cycle, the more liquid the company's working capital position is. The CCC is also known as the "cash" or "operating" cycle.

Formula:


Components:

DIO is computed by:

  1. Dividing the cost of sales (income statement) by 365 to get a cost of sales per day figure;
  2. Calculating the average inventory figure by adding the year's beginning (previous yearend amount) and ending inventory figure (both are in the balance sheet) and dividing by 2 to obtain an average amount of inventory for any given year; and
  3. Dividing the average inventory figure by the cost of sales per day figure.
For Zimmer's FY 2005 (in $ millions), its DIO would be computed with these figures:

(1) cost of sales per day 739.4 ÷ 365 = 2.0
(2) average inventory 2005 536.0 + 583.7 = 1,119.7 ÷ 2 = 559.9
(3) days inventory outstanding 559.9 ÷ 2.0 = 279.9

DIO gives a measure of the number of days it takes for the company's inventory to turn over, i.e., to be converted to sales, either as cash or accounts receivable.


DSO is computed by:
  1. Dividing net sales (income statement) by 365 to get a net sales per day figure;
  2. Calculating the average accounts receivable figure by adding the year's beginning (previous yearend amount) and ending accounts receivable amount (both figures are in the balance sheet) and dividing by 2 to obtain an average amount of accounts receivable for any given year; and
  3. Dividing the average accounts receivable figure by the net sales per day figure.
For Zimmer's FY 2005 (in $ millions), its DSO would be computed with these figures:

(1) net sales per day 3,286.1 ÷ 365 = 9.0
(2) average accounts receivable 524.8 + 524.2 = 1,049 ÷ 2 = 524.5
(3) days sales outstanding 524.5 ÷ 9.0 = 58.3

DSO gives a measure of the number of days it takes a company to collect on sales that go into accounts receivables (credit purchases).

DPO is computed by:
  1. Dividing the cost of sales (income statement) by 365 to get a cost of sales per day figure;
  2. Calculating the average accounts payable figure by adding the year's beginning (previous yearend amount) and ending accounts payable amount (both figures are in the balance sheet), and dividing by 2 to get an average accounts payable amount for any given year; and
  3. Dividing the average accounts payable figure by the cost of sales per day figure.
For Zimmer's FY 2005 (in $ millions), its DPO would be computed with these figures:

(1) cost of sales per day 739.4 ÷ 365 = 2.0
(2) average accounts payable 131.6 + 123.6 = 255.2 ÷ 125.6
(3) days payable outstanding 125.6 ÷ 2.0 = 63

DPO gives a measure of how long it takes the company to pay its obligations to suppliers.

CCC computed:
Zimmer's cash conversion cycle for FY 2005 would be computed with these numbers (rounded):


DIO 280 days
DSO +58 days
DPO -63 days
CCC 275 days
Variations:
Often the components of the cash conversion cycle - DIO, DSO and DPO - are expressed in terms of turnover as a times (x) factor. For example, in the case of Zimmer, its days inventory outstanding of 280 days would be expressed as turning over 1.3x annually (365 days ÷ 280 days = 1.3 times). However, actually counting days is more literal and easier to understand when considering how fast assets turn into cash.

Commentary:
An often-overlooked metric, the cash conversion cycle is vital for two reasons. First, it's an indicator of the company's efficiency in managing its important working capital assets; second, it provides a clear view of a company's ability to pay off its current liabilities.

It does this by looking at how quickly the company turns its inventory into sales, and its sales into cash, which is then used to pay its suppliers for goods and services. Again, while the quick and current ratios are more often mentioned in financial reporting, investors would be well advised to measure true liquidity by paying attention to a company's cash conversion cycle.

The longer the duration of inventory on hand and of the collection of receivables, coupled with a shorter duration for payments to a company's suppliers, means that cash is being tied up in inventory and receivables and used more quickly in paying off trade payables. If this circumstance becomes a trend, it will reduce, or squeeze, a company's cash availabilities. Conversely, a positive trend in the cash conversion cycle will add to a company's liquidity.

By tracking the individual components of the CCC (as well as the CCC as a whole), an investor is able to discern positive and negative trends in a company's all-important working capital assets and liabilities.

For example, an increasing trend in DIO could mean decreasing demand for a company's products. Decreasing DSO could indicate an increasingly competitive product, which allows a company to tighten its buyers' payment terms.

As a whole, a shorter CCC means greater liquidity, which translates into less of a need to borrow, more opportunity to realize price discounts with cash purchases for raw materials, and an increased capacity to fund the expansion of the business into new product lines and markets. Conversely, a longer CCC increases a company's cash needs and negates all the positive liquidity qualities just mentioned.

Note: In the realm of free or low-cost investment research websites, the only one we've found that provides complete CCC data for stocks is Morningstar, which also requires a paid premier membership subscription.

Current Ratio Vs. The CCC
The obvious limitations of the current ratio as an indicator of true liquidity clearly establish a strong case for greater recognition, and use, of the cash conversion cycle in any analysis of a company's working capital position.


Nevertheless, corporate financial reporting, investment literature and investment research services seem to be stuck on using the current ratio as an indicator of liquidity. This circumstance is similar to the financial media's and the general public's attachment to the Dow Jones Industrial Average. Most investment professionals see this index as unrepresentative of the stock market or the national economy. And yet, the popular Dow marches on as the market indicator of choice.

The current ratio seems to occupy a similar position with the investment community regarding financial ratios that measure liquidity. However, it will probably work better for investors to pay more attention to the cash-cycle concept as a more accurate and meaningful measurement of a company's liquidity.

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