• Accounting , Corporate Strategy , Finance , Higher Level Management , Metrics and Ratios ,
• 26 Dec

Cash Conversion Cycle is really important for manufacturing companies. It tells us how many days it takes to go from investments in inventory and sales processes to cash flows. Another name for this is the Net Operating Cycle or Cash Cycle.  A low CCC could mean that the company is managing it’s operations well. I say could because it depends on how well your competition is doing. It’s advantageous to be able to convert inventory and resources back to cash quicker than your competitors. A negative Cash Conversion Cycle means that your suppliers are financing your operations.

I really like the Cash Conversion Cycle (CCC) because it’s a culmination of three important metrics.  It is useful for communicating to higher level management in a couple different ways. The first is that the CCC is a single measure that combines many important aspects of converting inventory to cash easily period over period. The second is that the drivers of this metric are easy to see and explain. The mechanics of breaking out the details for analysis doesn’t take a lot of mathematical gymnastics. This makes it an easy number to not only calculate quickly and accurately, but to effectively communicate and talk about in ways that make sense to non-finance people.

Cash Conversion Cycle

CCC = Inventory Conversion Period   +   Receivables Conversion Period   –   Payables Conversion Period

Inventory Conversion Period

This is the time it takes to acquire materials, manufacture, and then sell it. It’s best to do this on a per product or other dimensions so that you can determine which products or group of products are driving longer times. The metric becomes less relevant when you outsource production. This is because you could reduce this number to zero, possibly at reduced margins. Also, if customers pay faster than you pay your suppliers, then you aren’t “investing” cash to finance your inventory production and this metric isn’t very meaningful.

Receivables Conversion Period

Receivables Conversion Period is the time between the actual sale, and getting cash from the sale. We also call this the average collection period or Day Sales Outstanding (DSO) ratio. If you think of the previous formula as the average time it takes to go from raw materials to sales, then this formula would naturally come right after that in the process. This is how long on average does it takes you to go from a sale to collecting cash.

Payables Conversion Period

Payables Conversion Period is also called Days Outstanding Payables (DPO) ratio. It’s how long it takes to pay your suppliers on average. As the only part of the formula where there is a subtraction, it’s important to know good from bad ways of increasing this number.  It’s not sustainable to increase your cash on hand by not paying your suppliers or paying them so slowly that you incur penalties or unable to take advantage of discounts.  On the other hand, if the power of suppliers is low compared to your buying power, you may be able to negotiate better terms. Having a healthy relationship with suppliers is important so think long term before digging in your heels for better terms.

Other Considerations

When comparing CCC ratios between companies, make sure that they are similar and that the comparison makes sense. Some industries will tend to have longer cycles, for example building a large cargo ship.