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

The cash conversion cycle (CCC) measures the number of days a company's cash is tied up in the production and sales process of its operations and the benefit it derives 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.

 

The calculation

 

(Days inventory outstanding + days sales outstanding) – days payables outstanding

 

  • Days inventory outstanding is a measurement of how long it takes to convert the company’s outstanding inventory into cash. This metric is calculated by dividing the company’s average inventory by its cost of sales per day.

  • Days sales outstanding is calculated by dividing the average accounts receivable figure by the net sales per day figure. DSO provides an estimate of how long it takes the company to collect on sales that go into the company’s accounts receivable.

  • Days payables outstanding is calculated by dividing the company’s average accounts payable figure by its cost of sales per day. DPO provides an estimate of how long it takes the company to pay its suppliers.

 

Why the cash conversion cycle matters

 

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.

 

The cash conversion cycle looks 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. While the quick and current ratios are more often mentioned in financial reporting, investors would be well-advised to look at this metric as a measurement of the true liquidity of a company.

 

The longer that inventory is on hand, the longer it takes to collect accounts receivables. Combined with a shorter duration for payments to the company's suppliers, this indicates that cash is being tied up in inventory, receivables and is being used more quickly to pay trade payables. If this situation becomes a trend, it will reduce, or squeeze, a company's available cash. Conversely, a positive trend in the cash conversion cycle will add to a company's liquidity.

By tracking the individual components of the CCC an investor can spot positive and negative trends in the company’s working capital management.

A shorter CCC means greater liquidity, which translates into less need to borrow, more opportunities to realize price discounts with cash purchases for raw materials and an increased capacity to fund the expansion of the business. Conversely, a longer CCC increases the company's cash needs.

Current and quick ratios vs. the CCC

The limitations mentioned in previous sections regarding the current and quick ratios as an indicator of a company’s true liquidity make a strong case for looking at the cash conversion cycle to analyze a company's working capital position.

 

 


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