The cash conversion cycle (CCC) is one of several measures of management effectiveness. It measures how fast a company can convert cash on hand into even more cash on hand. The CCC does this by following the cash as it is first converted into inventory and accounts payable (AP), through sales and accounts receivable (AR), and then back into cash. Generally, the lower this number is, the better for the company. Although it should be combined with other metrics (such as return on equity and return on assets), the cash conversion cycle can be especially useful for comparing close competitors because the company with the lowest CCC is often the one with better management. In this article, we'll explain how CCC works and show you how to use it to evaluate potential investments.
What Is It?
The CCC is a combination of several activity ratios involving accounts receivable, accounts payable and inventory turnover. AR and inventory are short-term assets, while AP is a liability; all of these ratios are found on the balance sheet. In essence, the ratios indicate how efficiently management is using short-term assets and liabilities to generate cash. This allows an investor to gauge the company's overall health.
How do these ratios relate to business? If the company sells what people want to buy, cash cycles through the business quickly. If management cannot figure out what sells, the CCC slows down. For instance, if too much inventory builds up, cash is tied up in goods that cannot be sold – this is not good news for the company. To move out this inventory quickly, management might have to slash prices, possibly selling its product at a loss. If AR is handled poorly, it means that the company is having difficulty collecting payment from customers. This is because AR is essentially a loan to the customer, so the company loses out whenever customers delay payment. The longer a company has to wait to be paid, the longer that money is unavailable for investment elsewhere. On the other hand, the company benefits by slowing down payment of AP to its suppliers, because that allows it to make use of the money longer.
The Cash Conversion Cycle
To calculate CCC, you need several items from the financial statements:
Inventory, AR and AP are found on two different balance sheets. If the period is a quarter, then use the balance sheets for the quarter in question and the ones from the preceding period. For a yearly period, use the balance sheets for the quarter (or year end) in question and the one from the same quarter a year earlier.
This is because, while the income statement covers everything that happened over a certain time period, balance sheets are only snapshots of what the company was like at a particular moment in time. For things like AP, you want an average over the time period you are investigating, which means that AP from both the time period's end and beginning are needed for the calculation.
Now that you have some background on what goes into calculating CCC, let's look at the formula:
CCC = DIO + DSO - DPO
Let's look at each component and how it relates to the business activities discussed above.
Days Inventory Outstanding (DIO): This addresses the question of how many days it takes to sell the entire inventory. The smaller this number is, the better.
DIO = Average inventory/COGS per day
Average Inventory = (beginning inventory + ending inventory)/2
Days Sales Outstanding (DSO): This looks at the number of days needed to collect on sales and involves AR. While cash-only sales have a DSO of zero, people do use credit extended by the company, so this number will be positive. Again, a smaller number is better.
DSO = Average AR / Revenue per day
Average AR = (beginning AR + ending AR)/2
Days Payable Outstanding (DPO): This involves the company's payment of its own bills or AP. If this can be maximized, the company holds onto cash longer, maximizing its investment potential; therefore, a longer DPO is better.
DPO = Average AP/COGS per day
Average AP = (beginning AP + ending AP)/2
Notice that DIO, DSO and DPO are all paired with the appropriate term from the income statement, either revenue or COGS. Inventory and AP are paired with COGS, while AR is paired with revenue.
Let's use a fictional example to work through. The data below are from a fictional retailer Company X's financial statements. All numbers are in millions of dollars.
|Item||Fiscal Year 2015||Fiscal Year 2016|
|Average Inventory||(1,000 + 2,000) / 2 = 1,500|
|Average AR||(100 + 90) / 2 = 95|
|Average AP||(800 + 900) / 2 = 850|
Now, using the above formulas, CCC is calculated:
DIO = $1,500 / ($3,000/ 365 days) = 182.5 days
DSO = $95 / ($9,000 / 365 days) = 3.9 days
DPO = $850 / ($3,000/ 365 days) = 103.4 days
CCC = 182.5 + 3.9 - 103.4 = 83 days
As a stand-alone number, CCC doesn't mean very much. Instead, it should be used to track a company over time and to compare the company to its competitors.
When tracking over time, determine CCC over several years and look for an improvement or worsening of the value. For instance, if for fiscal year 2015, Company X's CCC was 90 days, then the company has shown an improvement between the ends of fiscal year 2015 and fiscal year 2016. While the change between these two years is good, a significant change in DIO, DSO or DPO might merit more investigation, such as looking further back in time. CCC changes should be examined over several years to get the best sense of how things are changing.
CCC should also be calculated for the same time periods for the company's competitors. For example, for fiscal year 2016, Company X's competitor Company Y's CCC was 100.9 days (190 + 5 - 94.1). Compared with company Y, company X is doing a better job at moving inventory (lower DIO), is quicker at collecting what it is owed (lower DSO) and keeps its own money a bit longer (higher DPO). Remember, however, that CCC should not be the only metric used to evaluate either 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 doesn't pay its suppliers for the goods that it buys until after it receives payment for selling those goods. Therefore, Company Z doesn't need to hold very much inventory and still holds onto its money for a longer time period. Online retailers usually have this advantage in terms of CCC, which is another reason why CCC should never be used alone without other metrics.
The Bottom Line
The CCC is one of several tools that can help you evaluate management, especially if it is calculated for several consecutive time periods and for several competitors. Decreasing or steady CCCs are good, while rising ones should motivate you to dig a bit deeper.
CCC is most effective with retail-type companies, which have inventories that are sold to customers. Consulting businesses, software companies and insurance companies are all examples of companies for whom this metric is meaningless.