The cash conversion cycle (CCC) is a measure of how long it takes for a business to sell its stock, gather payments, and settle its debts. A shorter cash conversion cycle is preferable, as it means cash spends less time tied up in accounts receivable or inventory. CCC can differ depending on the industry or sector being looked at.
Understanding the Cash Conversion Cycle
The cash conversion cycle (CCC) is a great way to gauge how efficient a company is. It looks at how well a business’s operations and management are functioning. By keeping an eye on a company’s CCC over several quarters, you can see if it’s getting better, staying the same, or getting worse in terms of operational efficiency.
When cash flows in regularly, a company can boost its sales and profits since having capital means it can produce and sell more products. If a company buys inventory on credit, it creates accounts payable (AP). Similarly, selling products on credit leads to accounts receivable (AR).
Cash only becomes relevant when the company pays off its AP and collects its AR from customers. Timing plays a crucial role in managing cash. The CCC tracks the journey of cash throughout business activities. It follows cash as it moves through inventory and AP, then into expenses for developing products or services, onto sales and AR, and finally back into cash on hand.
The Calculation of Cash Conversion Cycle
The formula for calculating CCC is:
CCC=DIO+DSO−DPO
where:
DIO=Days of inventory outstanding
(also known as days sales of inventory)
DSO=Days sales outstanding
DPO=Days payables outstandingDIO and DSO relate to the cash coming into the company, whereas DPO is tied to the cash going out. DPO stands out as the only negative number in the equation.
DIO and DSO represent inventory and accounts receivable, respectively, which are seen as short-term assets and have a positive impact. On the other hand, DPO is associated with accounts payable, a liability that is viewed as negative.
The Example
The cash conversion cycle is selectively relevant to various industries depending on how their business operates. This measure impacts retailers such as Walmart (WMT), Target (TGT), and Costco (COST), all of which purchase and manage inventory to sell to customers.
On the flip side, CCC doesn’t apply to businesses that don’t require inventory management. Take software companies, for example; they can generate sales through licensing without needing to handle stock. Likewise, insurance or brokerage firms don’t buy products in bulk for resale, so CCC isn’t relevant for them.
Retailers like Amazon (AMZN) can actually have a negative CCC. Online retailers often get payments for goods that are owned and fulfilled by third-party sellers using their platform. However, these companies don’t pay the sellers right away after a sale; instead, they might operate on a monthly or threshold-based payment schedule. This setup allows them to keep the cash for a longer period, resulting in a negative CCC.
Conclusion
When a business takes a long time to gather its accounts receivable, holds too much stock, or pays its bills too fast, it extends the CCC. A longer CCC means it takes more time to bring in cash. On the flip side, if a company collects payments swiftly, accurately predicts its inventory needs, or pays its expenses slowly, it reduces the CCC. A shorter CCC indicates that the company is in better shape. If two firms have comparable return on equity (ROE) and return on assets (ROA), investors might prefer the one with the lower CCC value. This suggests that the company can achieve similar returns in a shorter timeframe.