How to improve your cash conversion cycle
- 1 How to improve your cash conversion cycle
- 1.1 What is the cash conversion cycle?
- 1.2 Why is your cash conversion cycle important?
- 1.3 What is the difference between the cash conversion cycle and the operating cycle?
- 1.4 What if you have no inventory?
- 1.5 How do you calculate your cash conversion cycle?
- 1.6 How to analyze your cash conversion cycle number?
- 1.7 What does a positive CCC say about your business?
- 1.8 Financial strategies to improve your cash flow and cash conversion cycle
How to improve your cash conversion cycle
Do you know what your business’s cash conversion cycle (CCC) is?
If you run a retail-based business or one that maintains inventory and you want to do a better job of managing cash flow, this is an important metric that you need to understand and manage.
In this article, we will address the following common questions:
- What is the cash conversion cycle?
- Why is your cash conversion cycle important?
- What is the difference between the cash conversion cycle and the operating cycle?
- What if you have no inventory?
- How do you calculate your cash conversion cycle?
- How should you analyze your CCC number?
- What does a positive CCC say about your business?
- What are some financial strategies to improve your cash flow and CCC?
By the end of this tutorial, you’ll feel a lot more confident working with this important financial concept. Let’s go!
What is the cash conversion cycle?
Simply put, your CCC is the time it takes to convert resources, such as investments in production and sales, into cash flow. In an ideal world, this cycle should be as short as possible (45 days is a good standard) so your money doesn’t stay tied up in inventory or receivables for too long leading to cash flow problems .
Many things affect the duration of the CCC. For example, businesses that have negotiated longer payment terms with their suppliers will have shorter CCCs because cash doesn’t have to be paid quickly. On the other hand, if you extend a trade credit term to a customer, your CCC will be extended because they have a longer time to pay you. Slow sales and an economic downturn can also increase your CCC.
Why is your cash conversion cycle important?
CCC is a useful, and often overlooked, measure of your business’s cash performance and overall financial health. The quicker you can convert cash into cash flow (i.e., sell faster and collect payments faster), the shorter it will take you to reinvest that money back into the business. On the other hand, if your business has a long CCC, cash flow can become difficult and you may need to find working capital to finance both your operations and growth.
What is the difference between the cash conversion cycle and the operating cycle?
The life cycle of your business is similar to its CCC because both of these measures how well you are managing your cash. These two terms are often used interchangeably, but there is a difference.
While CCC measures the number of days it takes to convert resources into cash, the operating cycle is more specific in that it represents the time it takes from initial cash out to acquire inventory to receive payment for those sales from your customers. Thus, the life cycle is an indicator of how well your operations are performing, while the CCC provides insights into how you are managing your cash flow. Although slightly different, both cycles overlap. For example, a short duty cycle can lower your CCC and vice versa.
What if you have no inventory?
If you sell most of your merchandise online, chances are you don’t have physical inventory. That’s because most online retailers fulfill orders through their suppliers after they receive payment from the customer. This can lead to a very short or even negative CCC.
Don’t downplay the importance of calculating your CCC as it will help take into account any resources you’ve invested in carrying out those online sales activities, such as sales, marketing, closings, etc. package, etc
How do you calculate your cash conversion cycle?
Calculating your business’s CCC is an important exercise that aids any cash flow analysis and is a key indicator of how your company is managing its working capital. To calculate the CCC, you will need to collect data from your financial statements.
Let’s say you’re calculating your CCC in a quarter. Here is the data you will need:
- Revenue and cost of goods sold (COGS). COGS or cost of goods sold (COS) is a calculation of all costs involved in making or selling a product and can be found on your income statement.
- Inventory at the beginning of the quarter and at the end of the quarter. Find it on that quarter’s balance sheet.
- Accounts receivable and payable at the beginning of the quarter. Again, refer to your balance sheet.
- The number of days in the calculated period. 90 in the case of this example.
The formula for calculating CCC is as follows: DIO + DSO – DPO = Cash conversion cycle.
Here is an explanation of what these acronyms mean:
- DIO = Number of days in inventory. The number of days it takes to sell your entire inventory. The goal is to keep this number low. To arrive at this calculation, divide your average inventory (i.e. your starting and ending inventory for the period divided by two) by your cost of goods sold per day .
- DSO = Number of days of unpaid sales. Number of days required to collect payments for sales. If you only sell cash, your DSO is zero, if you extend the credit to include terms like 30-, 45-, or 90-day, this number will be higher. This practice is very common among businesses serving other businesses (B2B) – 60% use formal or informal trade credit systems. And for good reason. Trade credit allows a small business to get more revenue from cash-strapped businesses that can’t pay off immediately. To calculate your DSO, divide your average receivables (again, these are your start and end numbers for the period divided by two) by sales per day.
- DPO = Days Debt Payable (DPO). The number of days it takes to pay your bills. To calculate this number, divide your average accounts payable by the cost of goods sold per day.
If you don’t want to do the math yourself, Money-Zine offers a useful online cash conversion cycle calculator that simplifies the process.
How to analyze your cash conversion cycle number?
As with most business numbers, a single zero won’t tell you much. You’ll need to track your CCC number over time to see if it’s improving (smaller) or getting worse. Quarterly tracking is helpful, but plan for annual tracking and build comparisons to get a true picture of how any changes in sales or activity are affecting your numbers. friend.
Of course, there are a number of other financial metrics your business should track and different methodologies for sourcing the raw data on which your CCC is based. For this reason, some advisors, including Fortune 500 financial officer David K. Waltz, suggest making some restrictions on the conclusions we draw from the CCC calculation. Check out Waltz’s article, Cash Conversion Cycle – A Good Measure, for some insight into the “potholes in the road” you may encounter when trying to use the conversion cycle calculation. cash exchange.
What does a positive CCC say about your business?
A positive CCC gives some positive signals about your business, so if you have a CCC, congratulations. For example, a positive CCC could mean:
- You are smart about your inventory. Businesses with an active cash conversion cycle move inventory quickly. It also means you’re getting a good price on your product — you’re not selling at a huge discount just to ship it. You make smart decisions when it comes to customer needs and pivot quickly to changes in customer tastes.
- You collect what you are owed. Your company is the leader when it comes to collecting receivables. Maybe you even offer incentives to get your customers to pay on time. Once an invoice is past due, it will be more expensive and time consuming to send money down. Your positive cash conversion cycle means you may not have a large amount of uncollectible debt, which could affect operations.
- You pay suppliers responsibly. CCC actively indicates that you pay your suppliers on time, but maximizes the time it takes to transfer payments. Cash availability is important. When you pay suppliers, those funds won’t be available to buy inventory or meet payroll. An active cash conversion cycle could mean you’ve negotiated due dates for all of your payments so you have more time to put the cash to work for you.
- Lenders may love you. Lenders consider cash flow when making decisions about a company’s interest rate and loan amount. A positive cash conversion cycle shows your lenders getting the most out of your profits.
Read on to learn more about why your cash conversion cycle matters.
All of these are great indicators of the health of your business. Of course, having an active cash conversion cycle doesn’t automatically mean you’re in the clear. It’s just one of many important metrics to track.
Financial strategies to improve your cash flow and cash conversion cycle
Improving your CCC involves some general cash flow management techniques. This includes finding ways to move inventory faster, maximize the amount of time it takes to pay your suppliers, speed up the receivables process, and of course, reduce costs and improve revenue if possible.
It is important to consider the financing strategies available to you that can help overcome some of the causes of prolonged cash conversion cycles and cash flow problems, such as challenges in extending trade credit and dealing with late paying customers. If you find that your CCC isn’t as healthy as it should be, consider working capital financing options so you can keep your business afloat while addressing the basics with your CCC. me.