The ultimate guide to cash conversion cycle for FP&A teams

Mastering your cash conversion cycle is essential for maintaining liquidity and optimizing your operations and inventory.

This ultimate guide will walk you through everything you need to know, from the basic concepts and formulas to practical examples and advanced strategies.

Whether you're looking to improve inventory turnover or understand the implications of a negative cash conversion cycle, this blog is designed to help you discover the intricacies of the cash conversion cycle and maximize its potential for your business.

What is a cash conversion cycle?

The cash conversion cycle measures how long it takes a company to turn the money spent on inventory and resources into cash from sales. A shorter cycle means more efficient operations. To calculate your cash conversion cycle, you need data on days inventory outstanding (DIO), days sales outstanding (DSO), and days payable outstanding (DPO).

What does the cash conversion cycle measure?

The cash conversion cycle measures how long a company's money is tied up in producing and selling products before it's converted back to cash. It includes the time to sell inventory (DIO), the time to get paid (DSO), and the time to pay suppliers (DPO).

Cash conversion cycle benefits

The cash conversion cycle helps businesses evaluate the efficiency of their operations, liquidity, and cash position. It provides visibility into how quickly your company can convert invested cash from the initial investment to returns.

What is a negative cash conversion cycle?

A negative cash conversion cycle means a company sells its inventory and collects cash faster than it pays its suppliers. This effectively means suppliers are funding the business. While this can be good for cash flow, it requires careful management to maintain supplier relationships and avoid liquidity issues.

What does knowing your cash conversion cycle help you do?

Understanding your cash conversion cycle can help you:

1. Evaluate your company’s financial health – If you have a low cash conversion cycle (CCC), you can more easily convert inventory and receivables into cash for investments and projects, positioning your business better for growth.
2. Improve relationships with vendors – A low CCC signals to your vendors that you pay your invoices on time, making your business a more attractive partner.
3. Increase access to capital – Your CCC can improve your access to capital and loans by demonstrating to banks that you have cash available for debt repayments.

Cash conversion cycle formula

With a better understanding of what a cash conversion cycle is and how it can benefit your business, let’s look at the formulas used to calculate cash conversion cycle. In its simplest form, the formula used to calculate cash conversion is:

Cash conversion cycle = [days inventory outstanding (DIO) + days sales outstanding (DSO)] - days payables outstanding (DPO)

However, there is a lot of data that you must compile before arriving at the above formula, including:

• Revenue and cost of goods sold (COGS) from the income statement
• Inventory levels at the start and end of the period
• Accounts receivable (AR) at the beginning and end of the period
• Accounts payable (AP) at the start and end of the period
• The duration of the period (e.g., 365 days for a year, 90 days for a quarter)

Days inventory outstanding (DIO) formula

The first metric of your cash conversion cycle is calculating your days inventory outstanding (DIO). DIO is a measure of how long it will take your business to sell its current level of inventory. This is calculated using the formula:

DIO = (Average inventory / COGS) × 365 days

Where:
DIO = Days inventory outstanding
COGS = Cost of goods sold

​Since DIO represents how much of a company’s cash is tied up in inventory, the lower your DIO metric, the better, as this improves your inventory management. To improve your CCC with a lower DIO, you should reduce your inventory levels or increase sales.

Days sales outstanding (DSO) formula

The next part of your cash conversion cycle is your days sales outstanding (DSO). DSO measures how long it takes to collect cash from sales, and uses the formula:

DSO = (Avg. accounts receivable / revenue per day) x 365

​Where:
DSO = Days sales outstanding
Avg. accounts receivable = ½ × (BAR+EAR)
BAR = Beginning AR
EAR = Ending AR

​Much like DIO, it’s preferrable to have a lower DSO, as it indicates that you can collect cash quickly, enhancing your cash position.

Days payables outstanding (DPO) formula

And finally, days payables outstanding (DPO) is the last metric in your cash conversion cycle. The formula for DPO is:

DPO = (Avg. accounts payable / COGS per day​) x 365

Where:
DPO = Days payables outstanding
Avg. Accounts Payable= ½ × (BAP+EAP)
BAP = Beginning
EAP = Ending
COGS = Cost of goods sold​

DPO measures how much a company owes its suppliers, and how long it takes to pay off these debts. In contrast to other cash conversion metrics, a higher DPO is generally preferable as it indicates the company is taking longer to pay its bills, thereby conserving cash.

How to interpret a cash conversion cycle: what is a good cash conversion cycle?

While cash conversion metrics provide visibility into a company’s cash standing, including the efficiency of converting inventory into sales and then into cash, there is no standard “good” cash conversion cycle. In fact, many companies that have a negative cash conversion cycle are still successful and better able to weather change because they can operate with less working capital.

Take Amazon for example. Their inventory is primarily owned, managed, and sold by third parties. Amazon pays its vendors monthly, which often results in a negative cash conversion cycle, but it’s still one of the most successful online retailers.

A company’s industry also influences its cash conversion cycle, which may raise or lower it based on contributing factors. Retail businesses generally carry significantly more inventory than manufacturing companies, and thus may have a higher cash conversion cycle on average.

In addition, cash conversion cycle is tracked over multiple quarters to understand if a company is operating efficiently, so there is no standard “good” cash conversion cycle.

High vs. low cash conversion cycle

Despite there being no standard for a “good” cash conversion cycle, it is almost always preferable to have a low cash conversion cycle versus a high one. This indicates you’re receiving payments for the products you sell in a timely manner and consequently paying your suppliers for the products they manufacture for you. A low cash conversion cycle means you have access to cash more quickly should you need to make a new investment, pivot your corporate strategy, or react to market changes.

Positive vs. negative cash conversion cycle

As we discussed above, Amazon is one business that is known for having a negative cash conversion cycle. This means that they sell products significantly faster than they pay their suppliers. And while this isn’t always ideal for vendor relationships, it ensures that Amazon always has a significant amount of cash available for new investments.

In contrast, a positive cash conversion cycle is generally more concerning for businesses, as it indicates that suppliers are paid well before the product is sold. This may indicate a mismatch between product offerings and their target market, or an economic downturn like a recession. However, some industries naturally have longer cash conversion cycles, and this doesn't necessarily indicate poor performance. As such, for the resilience of the business, it’s often preferable to have a shorter or negative cash conversion cycle rather than a longer or positive one.

Less than 30 days

Many businesses strive to have a cash conversion cycle that’s less than 30 days. However, this means that an organization’s finance team must be incredibly diligent about managing accounts payables and accounts receivables.

Between 30-60 days

A cash conversion cycle between 30-60 days is most common. It indicates there is some room for improvement around inventory, accounts receivable, and accounts payable management.

Greater than 60 days

A cash conversion cycle greater than 60 days generally indicates there is significant room for improvement in the organization. Companies in this category should make immediate changes to their working capital management to ensure their survival. However, it's important to consider industry standards, as some industries naturally have longer cash conversion cycles.

Can a cash conversion cycle be too low? 

Generally speaking, no, a cash conversion cycle cannot be too low. However, if your company significantly delays payments to your suppliers, or if your suppliers take a long time to deliver your products after you’ve paid, this can strain relationships and make it difficult to operate your business effectively. Additionally, overly aggressive inventory reductions could lead to stockouts and lost sales, which may negatively impact customer satisfaction and revenue.

Cash conversion cycle example

To put your knowledge into practice, let’s look at a cash conversion cycle example.

Cash conversion cycle calculation example

Let’s consider the cash conversion cycle of retail business, Business A. First, we need to calculate the business’s days inventory outstanding (DIO). Their inventory is worth $2 million, and its cost of goods sold for the year is $15 million. To calculate DIO, we use the formula:

DIO = (Average inventory / COGS) × 365 days
DIO = ($2,000,000/$15,000,000) x 365 = 48.6 days

This means that Business A holds inventory for an average of 48.6 days before its sale.

Next, we need to calculate days sales outstanding (DSO). Business A has $500,000 outstanding in accounts receivables, and a revenue of $10 million. To calculate DSO, we use the formula:

DSO= (Avg. accounts receivable / revenue per day) x 365
DSO = ($500,000/$10,000,000) x 365 = 18.25 days

This means it takes about 18.25 days for Business A to receive payments once the goods are sold.

And finally, before calculating the cash conversion metric, we need to evaluate days payables outstanding (DPO). Business A has an accounts payable balance of $1 million, and their cost of goods sold (COGS) is $15 million. To calculate DPO, we use the formula:

DPO = (Avg. accounts payable / COGS per day​) x 365
DPO = ($1,000,000/$15,000,000) x 365 = 24.3 days

This indicates that it takes Business A 24.3 days to pay an invoice after it has been received.

Cash conversion cycle = [Days inventory outstanding (DIO) + Days sales outstanding (DSO)] - Days payables outstanding (DPO)

Cash conversion cycle = (48.6 days + 18.25 days) – 24.3 days = 42.55 days.

We now know that Business A’s cash conversion cycle is 42.55 days.

Cash conversion cycle analysis example

Business A’s cash conversion cycle is 42.55 days, which is within the ideal 30-to-60-day range. There are likely some improvements that Business A can make to their inventory and capital management to reduce their cash conversion cycle to less than 30 days. Some actions that Business A could take to improve their cash conversion cycle include:

• Optimize inventory management:
  • Utilize data analytics to better predict demand and streamline stock levels.
  • Negotiate faster delivery schedules with suppliers.
• Enhance accounts receivable processes:
  • Offer early payment discounts to incentivize quicker payments from customers.
  • Implement automated invoicing and follow-up systems to minimize delays.
  • Strengthen credit policies to ensure timely payments.
• Refine accounts payable strategies:
  • Develop strategic relationships with key suppliers to negotiate better payment terms.
  • Use dynamic discounting to take advantage of early payment discounts when cash flow allows.
  • Monitor and manage payment schedules to maintain healthy supplier relationships without compromising liquidity.

By focusing on these areas, Business A can potentially reduce its cash conversion cycle to less than 30 days. This would not only enhance operational efficiency but also bring significant financial benefits, positioning the company for sustained growth and success.

Uses of the cash conversion cycle

Next, let’s look at how you can use your cash conversion cycle to evaluate your business performance, contextualize your income, improve relationships with vendors, and gain access to capital and loans.

Evaluating company performance

By tracking your cash conversion cycle over time, you can better understand your company’s performance when it comes to managing accounts payables, receivables, and inventory. If your cash conversion cycle increases over time, you can reduce the amount of inventory you keep, adjust your payment terms, or work with your vendors to establish new timelines for settlements.

Evaluating competitors

You can also use your cash conversion cycle to compare your company’s performance against your competitors. By calculating your competitor’s cash conversion cycle, you can determine if they are selling inventory faster, collecting receivables more quickly, or holding on to cash longer. This insight can then inform your approach to capital and inventory management, making your business more competitive.

Contextualizing net income

Your cash conversion cycle should not be evaluated by itself, but rather in conjunction with metrics like gross margin, net profit margin, and return on assets. Understanding how the cash conversion cycle impacts these metrics can provide a more comprehensive view of your financial health.

Improving trade credit terms with vendors

If you have a high cash conversion cycle, this is an opportune time to improve trade credit terms with vendors. This can ensure you receive your inventory more quickly while your vendors get their payments sooner. Negotiating better terms can improve your cash flow and enhance supplier relationships, contributing to a more efficient supply chain.

Getting easier access to capital and loans

A low cash conversion cycle demonstrates to banks and other lenders that you can pay your debts in a timely manner. As a result, it can make it easier for your business to access capital and loans, allowing you to scale faster.

Discussion: Inventory turnover and improving cash conversion cycle

Ultimately, cash conversion cycle is a measure of how fast your company turns money spent on inventory and resources into cash from sales. And a lot of this comes down to how quickly you can turn over your inventory. However, the goal is not to continually shorten these collection cycles, it’s to prevent your customers and your business from falling behind on payments, which in turn limits your access to cash.

A Financial Performance Platform, like Prophix One, offers a solution for managing and optimizing your cash conversion cycle through meticulous cash flow planning. Leveraging automation capabilities, Prophix One delivers real-time insights into your financial status, enhancing your ability to make informed and proactive decisions.

Discussion: What causes a negative cash conversion cycle?

As we mentioned above, Amazon is one such retailer that has a negative cash conversion cycle. This is partly because their inventory includes products managed by third parties, which means that payments are made to these vendors on an extended basis, significantly lowering Amazon’s cash conversion cycle. Additionally, Amazon receives payment from customers upon the sale of an item but pays its suppliers on extended terms, often monthly. This means Amazon holds onto cash for longer. While it’s not always ideal to have a negative cash conversion cycle, for companies like Amazon, this allows them to keep more cash on hand for new investments or market changes

FAQs about the cash conversion cycle

What is the cash conversion cycle formula?

The cash conversion cycle formula is:

Cash conversion cycle = [days inventory outstanding (DIO) + days sales outstanding (DSO)] - days payables outstanding (DPO)

What does a high CCC mean?

A high cash conversion cycle (CCC) means that it takes a company a long time to turn cash spent on inventory into cash from sales. It may also indicate that a company has slow collections from its customers or holds onto inventory for longer periods. A high CCC often reflects the typical practices of a company's industry, particularly those with longer production or sales cycles.

What are the three components of the cash conversion cycle?

The three components of the cash conversion cycle are days inventory outstanding (DIO), days sales outstanding (DSO), and days payables outstanding (DPO).

What is a bad cash conversion cycle?

There is not a universally “bad” cash conversion cycle. However, most companies aim for a cash conversion cycle of less than 60 days to ensure they have cash available for operational expenses, new investments, and to maintain liquidity during periods of uncertainty.

Do you want a longer or shorter cash conversion cycle?

Generally, it's preferable to have a shorter cash conversion cycle to ensure you receive payments from customers and pay vendors in a timely manner. Additionally, a shorter cycle can help guarantee that you have enough inventory on hand to meet demand.

Is a negative cash conversion cycle sustainable?

For most businesses, maintaining a negative cash conversion cycle can be challenging but potentially beneficial. While it allows a company to receive payments from customers before paying suppliers, mismanagement can negatively affect relationships with vendors, result in cash flow issues, and limit the amount of inventory the company can carry.

Conclusion: Master your cash conversion cycle

Mastering the cash conversion cycle is a critical skill for any FP&A team aiming to boost liquidity and streamline operations.

By understanding its components, calculating it accurately, and implementing strategies to optimize it, you'll be well-equipped to enhance your company's financial performance. Whether you're improving inventory turnover or managing a negative cash conversion cycle, these insights will empower you to make informed decisions.

See how Prophix One can help you manage your cash flow.