Cash Conversion Cycle: Definition, Formulas, and Example

The cash conversion cycle is the amount of time a company needs or takes to convert funds invested in production and sales to cash. It is used to measure the company's efficiency in using its working capital.

Learn more about the cash conversion cycle and how to calculate it and use it in an analysis.

What Is the Cash Conversion Cycle (CCC)?

The cash conversion cycle (CCC) is one of several metrics used to gauge how well management uses working capital. Working capital is the money used in day-to-day operations. This metric measures the amount of time a company takes to turn money invested in operations into cash.

The CCC uses the average times to pay suppliers, create inventory, sell products, and collect customer payments. Generally, the shorter this timeframe is, the better it is for the company.

Understanding the Cash Conversion Cycle (CCC)

The CCC combines several activity ratios involving outstanding inventory and sales, accounts receivable (AR), and accounts payable (AP). Outstanding inventory is inventory that has not been sold, accounts receivable are the accounts that the company needs to collect on, and accounts payable are accounts the company needs to make payments to.

To calculate CCC, you need to collect information from the company's financial statements:

• Average inventory over the period
• Cost of goods sold or cost of sales
• Accounts receivable balance
• Annual revenue
• Ending accounts payable

You use this information to calculate days of inventory outstanding, days of sales outstanding, and days of payables outstanding.

Days of Inventory Outstanding (DIO)

DIO is how many days it takes to sell the entire inventory. The smaller the number, the better. To calculate it, you first need to determine average inventory:

(Beginning Inventory + Ending Inventory) / 2

Then, use it to calculate DIO:

Average Inventory / Cost of Goods Sold

Days of Sales Outstanding (DSO)

DSO is days sales outstanding or the number of days a company takes to collect on sales. First, calculate the average accounts receivable (AR):

Average accounts receivable ÷ 2

Then, calculate the DSO:

(Accounts Receivable / Annual Revenue) x Number of Days in Period

Days of Payables Outstanding (DPO)

DPO is days payable outstanding. This metric reflects the company's payment of its own bills or accounts payable (AP). If this can be maximized, the company holds onto cash longer, maximizing its investment potential. Therefore, a longer DPO is better.

Ending Accounts Payable / (Cost of Sales / Number of Days)

Cash Conversion Cycle

You then use the value for each element to calculate the Cash Conversion Cycle:

Days inventory outstanding + Days sales outstanding - Days payables outstanding

Example of the Cash Conversion Cycle

Here's an example—the data below are from the financial statements of a fictional retailer, Company X. All numbers are in millions of dollars.

Now, using the above formulas, the CCC is calculated:

• DIO = ($1,500 / $3,000) x 365 days = 182.5 days
• DSO = ($95 / $9,000) x 365 days = 3.9 days
• DPO = $850 / ($3,000 / 365 days) = 103.4 days
• CCC = 182.5 + 3.9 - 103.4 = 83 days

Using the Cash Conversion Cycle

On its own, CCC does not mean very much. Instead, it should be used to see if a company is improving over time and to compare it to its competitors. During an analysis, the CCC should be combined with other metrics—such as return on equity (ROE) and return on assets (ROA)—and can be useful when comparing competitors. The company with the lowest CCC is often—but not always—using its resources more efficiently.

Evaluating a Company

The CCC over several years can reveal an improving or worsening value when tracked over time. For instance, imagine Company X's CCC was 83 days for the fiscal year 2020. In 2021, the company had a CCC of 130—this is a decline between the ends of fiscal years 2020 and 2021.

You might think that the change between these two years is significant—and it is, but it should indicate to you that you should investigate more to find out what might have happened. Examine external influences like market and economic conditions to see if something affected sales. You may need to look at the separate elements of the calculation to determine what happened—suppliers or customers could have financial problems that affected payments, raw material shortages, or transportation issues that affected deliveries.

Evaluating Competitors

CCC should also be calculated for the same periods for the company's competitors to establish a comparison. For example, imagine Company X's CCC for the fiscal year 2021 was 130, and its direct competitor Company Y had a CCC of 100.9 days.

Compared with Company X, Company Y is doing a better job. It might be moving inventory quicker (a lower DIO), collects what it is owed faster (a lower DSO), or keeping its money longer (a higher DPO). However, remember that CCC should not be the only metric used to evaluate the company or the management; return on equity and return on assets are also valuable tools for determining management's effectiveness.

To make things more interesting, assume that Company X has an online retailer competitor, Company Z. Company Z's CCC for the same period is negative, coming in at -31.2 days. This means that Company Z does not pay its suppliers for the goods it buys until after it receives payment for selling those goods. Therefore, Company Z does not need to hold much inventory and still holds onto its money for a longer period. Online retailers usually have this advantage in terms of CCC, which is another reason why CCC should not be used in isolation without other metrics.

Special Considerations

The CCC is one of several tools that can help you evaluate performance, particularly if it is calculated for several consecutive periods and competitors. Decreasing or steady CCCs are a positive indicator, while rising CCCs require a little more digging.

CCC can also be applied to consulting businesses, software companies, insurance companies, or other companies without inventories. You'll get a negative result similar to the online retailer because you omit days inventory outstanding.