Cash flow isn’t just another financial term. It’s what keeps your business prospering. And in uncertain economic times, you want your cash flow to be positive.
The cash conversion cycle (CCC) uses cash flow data to inform decisions about operations and investments. You’ll see where cash gets tied up, if you have capacity to invest (for example, in more real estate), or if you can buy more inventory.
What is the cash conversion cycle?
A cash conversion cycle measures the time (in days) it takes to turn inventory investments, like clothing for an ecommerce store, into cash.
Think of it like your business metabolism. A fast (or low) CCC keeps your business lean, agile, and growing, while a slow (or high) CCC could indicate inefficiency and suboptimal cash flow.
The cash conversion cycle is an essential tool for making decisions and optimizing your operations because it reflects your operating cycle, which is the time it takes to get, market, and sell your product.
Gene Caballero, CFO of GreenPal, an online lawn care marketplace, says, “The CCC is an excellent indicator of business success because it shows how much cash is tied up in business operations. A low CCC indicates less risk, more cash for scaling the company, and higher returns for shareholders.”
The CCC is also important for business decision-making because it can:
- Improve working capital management
- Highlight inefficiencies like slow order processing or shipping delays
- Enhance investor confidence
- Signal operational efficiency
- Guide inventory decisions
For example, a distribution company taking three days to receive, handle, and ship goods would result in a higher CCC. But if that company took one day to process and ship orders, its CCC would decrease.
This lower CCC could provide more liquidity for future inventory, warehouses, or investments, resulting in higher net cash flow, assuming your cash outflows stay constant.
Which variables make up the cash conversion cycle?
The below variables help tell your business’s operational story, and you’ll need them before calculating your cash conversion cycle.
Before calculating your variables, you’ll need to choose a time frame (in days) for your CCC. It’s recommended that the time frame is at least 90 days, so you have enough data to be accurate.
Your average inventory is the value of your company’s inventory during the time period chosen. The formula is:
(Beginning inventory + Ending inventory) / 2
For example, if your company started the year with $10k in inventory and ended it with $15k, your average inventory would be $12.5k.
Cost of goods sold (COGS)
Cost of goods sold (COGS) is how much it costs to procure a company’s inventory during a given time period. The formula is:
Beginning inventory + Purchased inventory – Ending inventory
For instance, say a company begins the year with inventory worth $10k. In July, they spend $15k on additional inventory and end the year with $8k worth of inventory. The company’s cost of goods sold would be $17k.
Average accounts receivable
Your company’s average accounts receivable is the amount customers owe you during a set time period. The formula is:
(Beginning receivables + Ending receivables) / 2
Depending on your business model, you may offer loans on products or provide services before payment. Otherwise, this number may be zero for some businesses.
Total credit sales
Total credit sales is the amount of money customers owe your business from credit sales, which are purchases that are paid at a later date. For example, your company might offer a “buy now, pay later” function to encourage customers to buy more items.
The formula for total credit sales is:
Total sales – Total cash received
If your company doesn’t offer credit sales and requires upfront payment in full, your total credit sales will be zero.
Average accounts payable
Your average accounts payable is the money you owe to suppliers and creditors. This can vary depending on whether you pay upfront or later. The formula to calculate this is:
(Beginning accounts payable + Ending accounts payable) / 2
This calculation will also reflect part of your cash outflows.
How to calculate cash conversion cycle
To find out your cash conversion cycle, grab your financial statements and calculate your days inventory outstanding, days sales outstanding, and days payable outstanding. Then, follow the CCC formula: DIO + DSO – DPO = CCC
The cash conversion cycle formula
Here’s what the cash conversion cycle formula looks like:
Each variable is converted into days.
Days inventory outstanding (DIO): The average number of days it takes to sell your inventory. The formula is: Average inventory cost / Cost of goods sold * Time in days
Days sales outstanding (DSO): The average number of days it takes to collect customer payment. The formula: Average accounts receivable / Total credit sales * Time in days
Days payable outstanding (DPO): The average amount of time it takes to pay suppliers and creditors. The formula: Average accounts payable / Cost of goods sold * Time in days
Example of a cash conversion cycle
Say you run a ecommerce store that dropships mattresses, and you’re calculating your CCC for the year 2022.
First, gather all the data for each variable to calculate the DIO, DSO, and DPO.
DIO: If the average value of inventory is $2.5k and the COGS is $182.5k, you can multiply the total by 365 and get five days for days inventory outstanding.
$2,500 / $182,500 * 365 days = 5 days
DSO: Next, your company’s days sales outstanding is zero because you collect payment upfront and don’t offer credit sales.
0 / 0 * 365 days = 0 days
DPO: Given your store dropships mattresses, you’ll pay your supplier immediately, so your days payable outstanding will also be zero.
0 / $182,500 * 365 days = 0 days
Now, add your DIO and DSO, then subtract your DPO.
5 days + 0 days – 0 days = 5 days
Your cash conversion cycle is 5 days.
How to interpret the cash conversion cycle
Understanding the cash conversion cycle isn’t just about numbers — it’s about how they reflect your business efficiency. And while it may seem obvious, improving your CCC can transform how you scale your business.
Generally, a low CCC is a positive sign for businesses with daily obligations like inventory management or shipping. It means these operations are efficient, turning investments into cash without delay.
A low CCC is best for businesses looking to scale, pay shareholders, or navigate economic uncertainty.
For example, a health supplements company with a CCC of 15 days indicates a healthy business model with highly efficient operations. In the short term, this positive influx of cash can result in faster growth.
In the long term, the CCC may vary. With expansion comes obligations, so this supplements store’s cash conversion cycle may increase over time.
If the CCC increased to 30 days after six months of growth and reinvestment, it’s time to pull back and analyze what changed. This change could indicate a swing in operational inefficiency, likely due to an increase in DIO and average inventory.
A high CCC can slow growth, deter investors, and display suboptimal performance. It often reflects problems with inventory management, sales, or payment collection.
For instance, a distribution company with a CCC of 90 days has heavily restricted cash flow. This implies the company’s cash is not readily available for short-term operational needs or unexpected expenses.
The CCC can point to where the operational delay occurs. When calculating the variables for the CCC, you might find the inefficiency stems from slower inventory turnover, prolonged collection of receivables, or premature supplier payments that deplete cash reserves.
In some cases, a high CCC isn’t the worst metric in business. When supply chain issues happened in 2021, all companies involved had an increased CCC.
But in the long run, a high CCC could lead to challenges like stagnation, debt, and even bankruptcy, while a short CCC gives room for growth and reinvestments.
Thanks to online businesses, a negative cash conversion cycle is becoming more common. A negative CCC indicates that a business can collect payment before paying its suppliers, leading to a reliable influx of cash flow upon making sales.
This self-financing business model is an excellent way to scale a business, especially when it’s conducted online. For example, Amazon typically has a negative CCC because it turns over inventory and collects payment within a month, and pays suppliers about two months later.
The goal of calculating your cash conversion cycle is to fine-tune your operations by gaining a bird’s-eye view of your cash flow. Whether it’s adjusting payment terms with suppliers or improving your in-house operations, the CCC assists with essential financial and business decisions.