Understand the cash conversion cycle
- 1 Understand the cash conversion cycle
- 1.1 What is the company’s cash conversion cycle?
- 1.2 What is a good cash conversion cycle?
- 1.3 How to adapt to cash flow
- 1.4 What is the difference between the operating cycle and the cash conversion cycle?
- 1.5 Why the cash conversion cycle is important
Understand the cash conversion cycle
Small business owners need to pay close attention to many financial measures in order to run a profitable business. Although you may have indicators such as cash flow and sales forecasts, you may not be so diligent in monitoring the cash conversion cycle. The following details what is the cash conversion cycle, how to calculate it, and why it is important to you and any potential sources of financing you may come into contact with.
What is the company’s cash conversion cycle?
Sometimes called the net operating cycle or cash cycle or cash-to-cash cycle time, the cash conversion cycle (CCC) measures the time it takes for your business to convert cash to inventory, then to sales, and finally to cash. You can calculate the cash conversion cycle by calculating the time it takes to sell inventory, the time it takes to collect the receivables, and the time it takes to pay the accounts payable.
The three components of the cash conversion cycle are:
- Open inventory days (DIO). This is the average time it takes to convert inventory into finished products and then sell them. You can calculate DIO by dividing the average inventory by the cost of sales and then multiplying by 365.
- Days of open sales (DSO). This is the average number of days it takes for your accounts receivable to be collected. You can calculate DSO by dividing accounts receivable by net credit sales, and then multiplying by 365.
- Accounts payable days (DPO). This is the average length of time it takes for your business to purchase from a supplier and then pay (accounts payable). You get the DPO by dividing the accounts payable at the end of the period by (cost of sales ÷ 365).
The cash conversion cycle can be expressed as a formula:
CCC = Open inventory days (DIO) + Open sales days (DSO)-Open due days (DPO)
What is a good cash conversion cycle?
A good cash conversion cycle is very short. If your CCC is lower or (better) negative, it means that your working capital will not be occupied for a long time, and your business has greater liquidity. Many online retailers have low or even negative CCCs because they ship directly instead of maintaining inventory, get paid immediately when customers purchase products, and do not have to pay for inventory before customers have already paid.
If your CCC is a positive number, you don’t want it to be too high. Positive CCC reflects the number of days your business working capital is occupied while you are waiting for the payment of accounts receivable. If you sell products on credit and it usually takes 30, 60, or even 90 days for customers to pay you, your CCC may be very high.
You can shorten your company’s cash conversion cycle in many ways. On the one hand, make sure that your accounts receivable process is as efficient as possible. Sort out unnecessary terms in your invoice, and clarify the content of your invoice and the required terms. The faster the customer understands the invoice, the faster you can get paid. You can also shorten the CCC by requiring advance payments or offering discounts for advance payments. Finally, it is best to follow up immediately when the payment is due to understand the situation of the overdue payment.
How to adapt to cash flow
The cash conversion cycle is cash flow Calculate the time it takes for your business to convert inventory and other resources into cash. In other words, the cash-to-cash cycle time is the amount of time between when you pay for inventory and when customers pay to replenish your business’ cash flow.For companies with high inventory and material demand, such as put up, Keeping cash flow positive may make a difference between accepting new customers or rejecting them.
Conversion cycle calculations can help companies determine how long their cash is occupied before they collect cash from customers and customers. Paying close attention to a company’s CCC helps to monitor its overall financial situation as it flows in and out of cash. If you want to know the relationship between cash flow and profit, then the two are not the same thing. Although profit is the amount remaining after paying business expenses at a certain point in time, the cash flow is fluid. It represents the net flow of cash inflows and outflows from a company.
What is the difference between the operating cycle and the cash conversion cycle?
The operating cycle is from Buy Inventory and when the customer pays for the inventory.The cash conversion cycle is To pay Used for inventory and when to receive inventory payment from customers.
Why the cash conversion cycle is important
There are several reasons why it is important to monitor your cash conversion cycle:
- Investors, lenders, and other sources of financing often evaluate a company’s cash conversion cycle to determine its financial condition, especially its liquidity. The more liquid a company is, the easier it is to repay commercial loans, fulfill other financial obligations, and invest in growth. The cash conversion cycle is most useful for evaluating inventory-based businesses, such as retailers. It is not the only financial criterion used by financing sources; they usually combine it with other measures before deciding whether to issue a loan.
- Suppliers sometimes consider your CCC when deciding whether to extend your company’s credit. If your business lacks sufficient liquidity, they may worry that you will not be able to pay on time.
- The cash conversion cycle is also important to you. A low CCC indicates that you are doing a good job of converting inventory into cash and that your business is operating efficiently. On the other hand, if your CCC is too high, it may be a sign of operational problems, insufficient product demand, or a decline in market niche.If your CCC does not meet your preferences, please find out the problem and take measures to correct it, for example in Collect your invoice.
- Finally, when you determine how much money you need to borrow, your cash conversion cycle is an important metric. Knowing your CCC, and thus the liquidity of your business, can help you calculate how much cash you can claim from the lender.
Does your cash conversion cycle fail to meet the lender’s requirements? There are still ways to get the money you need. Consider alternative sources of financing, such as invoice-based financing from Fundbox.