What is the Cash Conversion Cycle - CCC

The cash conversion cycle (CCC) is a metric that expresses the length of time (in days) that it takes for a company to convert its investments in inventory and other resources into cash flows from sales. Also called the Net Operating Cycle or simply Cash Cycle, CCC attempts to measure the duration of time for which each net input dollar (cash) is tied up in the production and sales process before it gets converted into cash received through sales made to customers. This metric takes into account the duration of time it requires to sell its inventory, the duration of time required to collect receivables, and the duration of time the company is allowed to pay its bills without incurring any penalties.

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The Cash Conversion Cycle

BREAKING DOWN Cash Conversion Cycle - CCC

Selling more stuff for a profit is the primary way for a business to make more earnings. But how does one sell more stuff? If cash is easily available at regular intervals, one can churn out more sales for profits as frequent availability of capital leads to more products to make and sell. Usually a company acquires inventory on credit, which results in accounts payable (AP). A company can also sell products on credit, which results in accounts receivable (AR). Therefore, cash is not a factor until the company pays the accounts payable and collects the accounts receivable, and the timing becomes an important aspect of business from the point of view of cash management by the company.

CCC traces the time-based lifecycle of cash which is used for a business activity. It starts by following the cash as it is first converted into inventory and accounts payable, then into expenses for product/service development, through to sales and accounts receivable, and then back into cash in hand. Essentially, CCC represents how fast a company can convert the invested cash from start (investment) to end (returns). The lower this number, the better it is for a business.

Calculating CCC Through Various Business Stages

A company’s cash conversion cycle broadly moves through three distinct stages.

The first stage focuses on the existing inventory level and represents how long it will take for the business to sell its inventory. This figure is calculated by using the Days Inventory Outstanding (DIO). A lower value of DIO is preferred as it indicates that the company is making sales rapidly, and higher frequency implies more turnover for the business.

DIO is calculated based on cost of goods sold (COGS), which represents the cost of acquiring or manufacturing the products that a company sells during a period. Mathematically, 

DIO = Average inventory/COGS per day

where, Average Inventory = (Beginning Inventory + Ending Inventory)/2

The second stage focuses on the current sales and represents the duration of time it takes to collect the cash generated from the sales. This figure is calculated by using the Days Sales Outstanding (DSO). A lower value is preferred for DSO which indicates that the company is able to collect capital in a short time which enhances its cash position.

DSO = Average AR / Revenue per day

where, Average AR = (Beginning AR + Ending AR)/2

The third stage focuses on the current outstanding payable for the business. It takes into account the amount of money the company owes to its current suppliers for the inventory and goods it purchased, and represents the time horizon when the company is required to pay off those obligations. This figure is calculated by using the Days Payables Outstanding (DPO). Since it represents the outflow of cash from the business, a higher DPO value is preferred. By maximizing this number, the company is able to hold on to the cash for long and increases its investment potential.

DPO = Average AP/COGS per day

where, Average AP = (Beginning AP + Ending AP)/2

All the above mentioned figures are available as standard items in the financial statements filed by a publicly listed company as a part of its annual and quarterly reporting. The number of days in the corresponding period is taken as 365 for a year and 90 for a quarter.

Cash Conversion Cycle (CCC) Formula

Since CCC involves calculating the net aggregate time involved across the above three stages of the cash conversion lifecycle, the mathematical formula for CCC is represented as:

CCC = DIO + DSO - DPO

DIO and DSO are associated with company’s cash inflows, while DPO is linked to cash outflow. Hence, only DPO is the negative figure in the calculation. Another way to look at the formula construction is that DIO and DSO are linked to inventory and accounts receivable, respectively, which are considered as short term assets and are taken as positive. DPO is linked to accounts payable which is a liability, and is taken as negative.

Interpreting CCC

Inventory management, sales realization and payables are the three key ingredients of a business. If any of these goes for a toss – say, inventory being mismanagement, sales getting constrained, or payables becoming higher and frequent – the business is set to suffer. Beyond the monetary value involved, CCC accounts for the time-cycle involved in these processes that provides another view of the company’s operating efficiency. In addition to other financial measures, the CCC value indicates how efficiently a company’s management is using the short-term assets and liabilities to generate and redeploy the cash, and gives a peek into the company’s financial health with respect to the cash management. The figure also helps assess the liquidity risk linked to a company’s operations.

If a business has hit all the right notes and is efficiently serving the needs of the market/customer, it will have a lower CCC value.

CCC may not provide meaningful inferences as a stand-alone number for a given period. Analysts use it to track a business over multiple time horizons, and to compare the company to its competitors. Comparing a company’s CCC over multiple quarters indicates if it is improving or worsening its operational efficiency. While comparing competing businesses, investors may look at a combination of factors to select the best fit. If two companies are having similar values for return on equity (ROE) and return on assets (ROA), it may be worth investing in the company that has a lower CCC value. It indicates that the company is able to generate similar returns in shorter periods of time.

CCC is also used internally by the company’s management to adjust their methods of credit purchase payments or cash collections from debtors.

CCC Applies to Select Sectors

CCC has a selective application to different industrial sectors based on the nature of business operations. The measure has a great significance for retailers like Walmart Inc. (WMT), Target Corp. (TGT), and CostCo Wholesale Corp. (COST), which are involved in buying and managing inventories and selling them to customers. All such businesses may have a high positive value of CCC.

However, CCC does not apply to companies that don’t have needs for inventory management. For example, software companies like Microsoft Corp. (MSFT) offer computer programs as online downloads or through CD/DVD, and can realize sales (and profits) without the need to manage large stockpiles. Similarly, insurance or brokerage companies don’t buy stuff in wholesale and retail them and CCC does not apply to such businesses.

An interesting exception is the cash cycle of online retailers like eBay Inc. (EBAY) and Amazon.com Inc. (AMZN) which can have negative CCC values. Often, online retailers receive funds in their account for sale of goods which actually belong to and are served by third-party sellers who use the online platform. However, these companies don’t pay the sellers immediately after the sale, but may follow a monthly or threshold-based payment cycle. This mechanism allows these companies to hold onto the cash for a longer period of time, and they often end up with a negative CCC. Additionally, if the goods are directly supplied by the third-party seller to the customer, the online retailer doesn’t need to hold any inventory in house. A Harvard Business blogpost attributes the negative CCC as the important factor which helped Amazon successfully survive the dot com bubble of 2000. The operating method with negative CCC became a source of cash for the company, instead of being a cost for it.

The Bottom Line

CCC is one of several quantitative measures that can help in evaluating the efficiency of a company's operations and of the management. A trend of decreasing or steady CCC values over multiple periods is a good sign, while rising ones should lead to more investigation and analysis based on other factors. One should bear in mind that CCC applies only to select sectors which have high dependence on inventory management and related operations.