Cash conversion cycle: What it is and 4 tips to improve it

Prophix Imageprophix May 16, 2024, 8:00:00 AM

Navigating your business's finances without understanding the cash conversion cycle is like trying to sail a ship without a compass. It's crucial, yet often overlooked.

This guide breaks down what the cash conversion cycle is, why it matters, and provides four actionable tips to improve it—ensuring your financial journey is both smooth and profitable.

What is a cash conversion cycle?

A cash conversion cycle is a measure of the time (typically in days) it takes a company to convert cash spent on resources and inventory back into profit from selling their product or service. The cash conversion metric measures how efficient a company’s operations and management are, and the shorter the cash conversion cycle the better.

To calculate this metric, you need data on your days inventory outstanding (DIO), days sales outstanding (DSO), and days payable outstanding (DPO).

What does cash conversion cycle measure?

A cash conversion cycle measures how long a company’s dollars are tied up in the production and sale of their product or service, and how much time it takes to be converted into cash received.

This includes measuring the number of days it takes to turn inventory into sales (DIO), the average number of days it takes to be paid from a sale (DSO), and the number of days it takes to pay your suppliers (DPO).

What does the cash conversion cycle tell you?

The cash conversion cycle tells you how efficiently your company can move inventory, and therefore cash, through your organization, which impacts profitability. It reflects the time span between when a company pays out cash for inventory (or production costs) and when it receives cash from customer payments for that inventory, thus providing insights into the operational efficiency and working capital management of the company.

Cash conversion cycle gives you insight into the liquidity of your business, by measuring the operational efficiency and effectiveness of your working capital.

What is a good cash conversion cycle?

A “good” cash conversion cycle is the least possible number of days between when inventory is manufactured to when it was sold and paid for. This efficiency indicates a company is effectively managing its inventory, receivables, and payables to quickly convert its investments into cash.

For most businesses, a median 30-to-45-day cash conversion cycle is ideal, however, this can vary widely by industry. For example, services-based industries may have a longer cash conversion cycle on average, as they do not hold inventory in the same way product-based businesses do.

Companies with less than a 30-day cash conversion cycle are incredibly efficient at producing products, but also have a good relationship with their customers and suppliers. However, a very short cash conversion cycle could also indicate aggressive cash management practices that are not suitable in the long term.

What does a negative cash conversion cycle mean?

A negative cash conversion cycle means that a company can manufacture and sell inventory faster than it can pay its suppliers and expenses. In this scenario, your vendors are funding your business, as you have already sold inventory you haven’t yet paid for.

However, while a negative CCC can indicate a strong position in terms of cash flow and operational efficiency, it also requires careful management. Companies must ensure they maintain good relationships with their suppliers to sustain favorable payment terms and must manage their cash flows prudently to avoid potential liquidity issues should their sales cycle lengthen unexpectedly or if supplier terms change.

How to calculate cash conversion cycle

With a detailed explanation of a cash conversion cycle, you can begin gathering the data necessary to calculate your cash conversion metric.

Before calculating your cash conversion cycle, you need to determine the period you wish to calculate for (e.g., for the quarter or the year). You’ll also need to compile data from your balance sheet, including:

  • Costs of goods sold (COGS)
  • Inventory values
  • Accounts receivables
  • Accounts payables

Then, using this data, you can begin calculating the three metrics that make up your cash conversion cycle:

  • Days Inventory Outstanding (DIO): This is the average number of days it takes for a company to turn its inventory into sales. A lower DIO indicates that a company can convert its inventory into sales more quickly.
  • Days Sales Outstanding (DSO): This measures the average number of days it takes for a company to collect payment after making a sale. A lower DSO is preferable as it means the company collects payment faster.
  • Days Payable Outstanding (DPO): This represents the average number of days a company takes to pay its suppliers. A higher DPO is beneficial up to a point as it means the company retains cash longer, which could be used for other operational needs or investments.

Cash conversion cycle formula

To calculate DIO, DSO, and DPO, you can use the following formulas:

  • DIO = (Ending Inventory / COGS) * 365 (or the number of days in the period being analyzed)
  • DSO = (Ending Accounts Receivable / Total Credit Sales) * 365 (again, days in the period)
  • DPO = (Ending Accounts Payable / COGS) * 365

Then, to calculate your cash conversion cycle, use this formula:

  • CCC = DIO + DSO – DPO

This formula provides a comprehensive view of how cash flows through a company from purchasing inventory to collecting the proceeds from sales, after paying suppliers. A shorter CCC is generally seen as positive because it indicates that a company can quickly free up cash tied in operations, making it available for further investment or to increase liquidity.

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4 tips to improve your cash conversion cycle

With your metrics in hand, you can use the four tips below to improve your cash conversion cycle:

Optimize your inventory management

By closely monitoring inventory levels and aligning them with actual sales demand, you can avoid the pitfalls of excess stock. This careful balance ensures that you're not tying up cash in unsold inventory, ultimately reducing the Days Inventory Outstanding (DIO) component of your cash conversion cycle. Managing inventory effectively means responding to market demands, minimizing unnecessary storage costs, and freeing up capital for other growth-oriented investments.

Keep an open line of communication between sales and finance

Regular monitoring of your inventory and the corresponding sales can improve communication between the sales department and your finance team. With visibility into profitability, the sales team can help finance refine sales and inventory forecasts, provide insight on customer behavior and payment patterns, identify opportunities to negotiate better terms with suppliers, set realistic sales targets, and closely monitor performance against these goals.

Be proactive

By automating the collection of payments and sending out invoices as part of your cash conversion process, you can be more proactive in monitoring your accounts receivable and your accounts payable. Frequent reforecasting of your inventory and sales can also help you stay on top of your company’s profitability, allowing you to adjust as needed.

Use cash flow software

Perhaps the most beneficial tip for improving your cash conversion cycle is using cash flow software. By centralizing your data in one place, and automating recurring processes, you can easily track your cash flow in real-time, streamline invoice and payment processing, and improve inventory management. This not only enhances financial visibility but also allows for quicker decision-making and optimization of accounts receivables and payables.

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How cash flow software can help you improve your cash conversion cycle

Prophix One, a Financial Performance Platform, offers a direct path to managing and optimizing your cash conversion cycle through precise cash flow planning. With its capacity to automate and adjust cash inflows and outflows, you get immediate insights into your financial health, supporting proactive decision-making.

Our platform simplifies tracking, ensuring your decisions are made on the most current and accurate data available. Visual reports and AI-driven insights allow for early detection of potential cash flow disruptions, empowering you to act quickly and avoid setbacks.

By facilitating multi-year planning, Prophix One helps you fine-tune your cash management strategies, ensuring both immediate needs and long-term goals are met with confidence. Improve your cash conversion cycle with Prophix One and keep your business running efficiently and effectively.

Conclusion: How to do cash flow planning with accuracy and agility

Mastering your cash conversion cycle is key to improving your business’s financial agility and stability.

We’ve explored its importance, how to gauge a good cash conversion cycle, methods of calculation, and provided tips to enhance it. Implementing these strategies will ensure your cash flow is managed with precision and agility, positioning your business for sustained growth and success.

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