In simple terms, the cash conversion cycle is the length of time it takes for a company to convert resource inputs into cash flows it measures the time between outlay of cash and cash recovery.
The cash conversion cycle is one of several measures of management effectiveness. It measures how quickly a company can convert cash on hand into even more cash on hand. The cash conversion cycle 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.
Is your management contributing positively to shortening your cash conversion cycle?
The shorter the time span between outlay and recovery the better it is for the company. Although the cash conversion cycle should be combined with other measures (such as return on equity and return on assets), it can be especially useful for comparing close competitors, because the company with the lowest cash conversion cycle is often the one with better management.
It is, therefore, vital that management monitor the cash conversion cycle constantly. There are factors that will have a negative effect on the cash conversion cycle of a business such as too much stock or inventory of products, interest incurred on loans as well and outstanding payment from customers.
How to calculate a cash conversion cycle from financial statements:
- Revenue and cost of goods sold (COGS) from the income statement;
- Inventory at the beginning and end of the time period;
- Accounts receivable at the beginning and end of the time period;
- Accounts payable at the beginning and end of the time period; and
- The number of days in the period (year = 365 days, quarter = 90).
Calculation: CCC = DIO+DSO -DPO
- DIO represents days inventory outstanding
- DSO represents days sales outstanding
- DPO represents days payable outstanding
A company that is successful in shortening the cash conversion cycle does so in a number of ways:
- Payment for goods or services from your Debtors (Accounts Receivable) should be COD or within 30 days if on terms.
- Carry minimal stock and reorder on a Just In Time basis (JIT). This is especially valid for a manufacturing concern.
- Order stock against forward orders that are placed by clients so as not to sit with surplus stock. On Line stores are able to offer better pricing as a result of having the advantage of only ordering goods as and when they have a confirmed order with cash already in the bank. The cost of holding stock is completely negated and comes with a substantial saving.
Monitor and analyse cash conversion cycles of previous fiscal years to gauge which elements of the cash conversion cycle are moving negatively and take immediate remedial action to rectify the situation. This is of critical importance as these measures can move against you quickly and can be a “silent killer” in that your business could be starved of it’s lifeblood, Cash, whilst all other measures appear on the face of it to be moving in the right direction.
Get the right help to shorten your cash conversion cycle
Most entrepreneurs are not financial experts and they are not familiar with this type of financial calculation. It is advisable that entrepreneurs or small business owners who want to shorten their cash conversion cycle consult with a qualified and experienced financial practitioner. These can be sourced privately or through a specialist financial outsource company.
Financial outsource companies have teams of financial experts that are highly qualified, come with years of experience and have proven track records. These companies outsource their financial practitioners on a part-time, interim or project basis and have a large talent pool from which to draw so they will be able to provide the best financial expert that has had experience within your chosen industry.