A company’s Cash Conversion Cycle measures the approximate number of days it takes to generate cash return from its cash investment in the business. It is also called the cash cycle, cash flow cycle, cash-to-cash cycle and cash realisation model. A company will mostly prefer to buy any inventory or raw materials on credit, called Accounts Payable. Similarly, most of the time, they will sell that inventory on credit, called Accounts Receivables.
If your vendors are financing your business which means your inventories are sold out before you have to pay for them. If your business has greater liquidity, then it is called the negative Cash Conversion Cycle. So, when a Cash Conversion Cycle is a short or even a negative number, then it is called a good Cash Conversion Cycle.
Did you know? Apple has a “Negative” Cash Conversion Cycle. That’s Amazing! The CCC of Apple for the second quarter ended in June 2022 was -68.92, and this makes the company the one with better management.
Also read: What Is Branch Accounting? Learn About Branch Accounting Types & Examples
What is the Cash Conversion Cycle?
- Described as a ratio, the Cash Conversion Cycle (CCC) calculates the amount of time (measured in days) it takes for a business to convert its investment in inventory and other resources into cash flow generated from sales by the company.
- CCC, also known as the Net Operating Cycle, measures how long money is held in the production and sales processes before it is converted into cash.
- This metric calculates how long it takes for a company to sell inventory, collect receivables, and pay bills. It also calculates the time taken for a company to sell its inventories.
- An organisation’s CCC is one quantitative measure used to evaluate its management and operations efficiency.
- One should bear in mind that CCC applies only to select sectors dependent on inventory management and related operations.
- CCC only applies to certain sectors that depend on inventory management and related activities.
Three Parts of the Cash Cycle
The cash cycle has three different parts in it. They are,
DIO – Days Inventory Outstanding
DSO – Days Sales Outstanding
DPO – Days Payable Outstanding
- DIO represents the current inventory level and the time taken for the company to sell this inventory.
- DSO represents the current sales and the time taken for the company to collect cash for these sales.
- DPO represents the amount of money the company has to pay its vendors and when the company is going to pay their vendors.
Also read: Understand Cash Accounting – Cash Account Meaning, Advantages And Limitations
How to Calculate Cash Conversion Cycle?
The Cash Conversion Cycle can be calculated by the below formula.
CCC = DIO + DSO – DPO
Where the DIO, DSO and DPO can be calculated by,
DIO = (Average of inventory/Cost of goods sold) *365
DSO = (Average of accounts receivables/Total credit sales) *365
DPO = (Average of accounts payable/Cost of goods sold) *365
Example: A company reported ₹1000 as beginning inventory and ₹3000 as ending inventory for the year ended 2018, with the cost of goods sold as ₹40,000. And it has ₹4000 as beginning Accounts Receivables and ₹6000 as ending Accounts Receivables, along with a credit sale of ₹1,20,000. Also, it has ₹1000 as beginning Accounts Payable and ₹2000 as ending Accounts Payable. Calculate CCC to assess the company’s cash conversion performance.
We can first calculate DIO, DSO and DPO using the formulas here.
To calculate DIO: Average inventory = (₹1000 + ₹3000)/2 = ₹2000
DIO = (₹2000/₹40000) *365 = 18.25
To Calculate DSO: Average accounts receivable = (₹4000 + ₹6000)/2 = ₹5000
DSO = (₹5000/₹1,20,000) *365 = 15.2
To Calculate DPO: Average accounts payable = (₹1000 + ₹2000)/2 = ₹1500
DPO = (₹1500/₹40,000) *365 = 13.69
Now, putting all the three together, CCC can be calculated as
CCC = DIO+ DSO – DPO
CCC = 18.25 + 15.2 – 13.69 = 19.76 days
Therefore, this company approximately takes 20 days to turn its investments in inventory into cash.
The Interpretation of the Cash Conversion Cycle
The main objective of calculating CCC is to assess how efficiently a company manages its working capital. The shorter the Cash Conversion Cycle, the better the company manages to sell inventories, recover cash from sales and pay suppliers.
Comparing the Cash Conversion Cycle of a company to that of its competitors or its previous cycles can help determine if the firm’s working capital management is improving or declining.
Also, comparing a company’s CCC to that of its competitors can help to determine if the company’s Cash Conversion Cycle is “normal”.
Who Can Use CCC?
Companies like business owners, investors, bankers, accountants and suppliers might use CCC to measure their cash flow. Cash flow decides the profitability of the company.
The CCC works better for the company having inventory as physical goods, whether it is manufactured items or retailed products.
Also read: What Is Accounting Rate of Return (ARR)? Explained With ARR Formula & Example
When Can a Company Use CCC?
Companies prepare documents such as balance sheets, profit and loss statements and cash flow statements to provide necessary information about the inventory and sales. Many companies prepare these either quarterly or annually. This helps to track CCC over some time to observe the trends. It helps to see how a company is improving or growing over some time.
Ideas to Improve Cash Conversion Cycle
Having a good CCC from the debtor’s side means fewer bad debts. Therefore, there would be no need to rely on external agencies or to record a large amount of uncollectible in the company’s books.
Using incentives, the firm can optimise its Cash Conversion Cycle. It may be possible for a firm to offer discounts if it wishes to reduce the collection period from the debtors.
The company faces several risks from old inventory remaining in storage houses, including high retention costs, spoilage risks and quality reductions. By improving the inventory conversion rate, the organisation can improve product quality and the bottom line.
On the payables side, a short conversion rate allows the firm to take advantage of the incentives provided by suppliers for instant payments. As a result, the relationship is improved, and the company can enjoy a shorter production cycle than its competitors.
Cash Conversion Cycle Ratio
Companies can turn investments into cash in a shorter amount of time using this ratio. CCC uses the average time to pay suppliers, create inventory, sell products, and collect customer payments. This timeframe should be as short as possible for the company, in general.
Negative Cash Conversion Cycle – ‘Apple’ and ‘Reliance Industries Ltd’ as Examples
An inventory that is sold before it needs to be paid for is said to have a negative Cash Conversion Cycle. To put it another way, your vendors are funding your business. Many businesses benefit from a negative Cash Conversion Cycle. One of the examples of this is Apple.
- Apple’s latest twelve-month cash conversion cycle is -46 days.
- Apple’s financial statements showed that the average cash conversion cycle for fiscal years ending September 2017 to 2021 was -66 days.
- During the fiscal years ending September 2017 to September 2021, Apple turned over cash at a median rate of -70 days.
- According to a five-year review, Apple’s cash conversion cycle reached -46 days in June 2022.
- With a cash conversion cycle of -74 days, Apple’s cash conversion cycle reached a five-year low in September 2019.
- In 2017, Apple’s cash conversion cycle decreased by 36%; in 2018, it decreased by 5.6%; in 2019, it decreased by 0.3%; and in 2020, it increased by 17.9% and 12% in 2021.
- The Company’s Days Payable for the three months ended in June of 2022 was 97.92. As a result, Apple’s Cash Conversion Cycle (CCC) for the three months ending in June 2022 was -63.92, which is a negative number.
Another example is Reliance Industries’ negative cash conversion cycle.
- Reliance Industries’ latest twelve-month cash conversion cycle is -12 days.
- From March 2018 to March 2022, Reliance Industries had an average cash conversion cycle of -22 days.
- Between the fiscal years ending March 2018 and 2022, Reliance Industries’ average cash conversion cycle was -19 days.
- In June 2022, the cash conversion cycle for Reliance Industries peaked at -12 days.
- March 2018 marked the lowest cash conversion cycle for Reliance Industries in five years.
- In 2018, the cash conversion cycle of Reliance Industries decreased by 36 days compared to 2016, 2021 and 2022, while increasing in 2019 by 25 days and 2020 by 13 days.
- The Days Payable for Reliance Industries’ three months ended in Jun. 2022 were 95.64. Hence, Reliance Industries’ Cash Conversion Cycle (CCC) ended in June 2022 at -20.87, which is a negative number.
So, a negative number on a CCC represents that the company’s performance is good, and it has a greater degree of liquidity with very less working capital tied up for long periods.
Also read: Learn about Inventory Accounting – Meaning, Objectives, Types & Method
Conclusion
Analysis of Cash Conversion Cycles is important because it informs us of the lock-in period for production-related investments. Analysing a company’s cash conversion can tell us a lot about how the company operates and what its prospects are. Cash flow cycles can be long if dues are not collected on time or if overproduction is taking place. Several problems can arise when a firm’s cash flow cycle is long because it is only possible to pay the bills through cash, not profits.
The most extreme of these problems is bankruptcy. If the number of days of the cash flow cycle is lower or even negative, the more efficiently the company can utilise its cash resources. It is beneficial for a business to see a lower operating cycle value because it promotes healthy working capital, cash flow, liquidity and profitability. In some cases, calculations will help you determine whether your business will succeed or not.
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