The Cash Conversion Cycle or CCC is one of the most important financial ratios that help depict the time period from which a company invests its resources such as inventories to gain cash on sales. In other words, CCC measures the adequacy of the Working Capital Management of a particular organization.
Therefore, knowledge and management of the CCC is crucial for companies to be able to keep, make and grow money. A shorter CCC shows that a company can easily get back its investments which is financially healthier for the company.
Through this article, you will be able to learn what CCC is, its formula with practical examples. And, it will definitely help your business cash cycle to optimize.
Concept of Cash Conversion Cycle (CCC)
CCC refers to the amount of time a firm takes to get cash from the purchase of inventory and the amount of cash that it takes to pay for the inventory also. It measures the time length for every dollar to tied up in production or sales cycle before transforming into cash.
Why CCC Matters for Businesses
Cash Conversion Cycles has been used as the measure of operating efficiency of a company. A shorter CCC means that a business is quickly converting inventories into cash. On the other hand, a longer CCC mean that a business is not properly managing it working capital. It is highly relevant to a business organization since it either increases or decreases profits. Therefore, it affects sustainability and growth of a certain business.
Components of Cash Conversion Cycle
Days Inventory Outstanding (DIO)
DIO calculates the average time that a firm has to keep inventory to sell it. It depicts how a company has been able to manage its stocks.
How to Calculate DIO: DIO = (Average Inventory /Cost of goods sold) * 365.
Days Sales Outstanding (DSO)
DSO refers to the length of time it takes for an organization to collect cash after making a sale. This one gives an indication of how healthy a firm is, in terms of recovering its receivables.
How to Calculate DSO: DSO = (Average Accounts Receivable / Net Credit Sales) * 365.
Days Payable Outstanding (DPO)
DPO estimates the overall number of days it takes to settle a company’s suppliers. It is an index of how sound a firm’s payment policy is in relation to the outgoing payments.
How to Calculate DPO: DPO = (Average of ‘Accounts Payable’/ ‘Cost of goods sold’) * 365.
Formula for Cash Conversion Cycle
The formula of CCC is CCC=DIO+DSO−DPO.
Examples of Cash Conversion Cycle Calculation
Example 1: Retail Business
Step-by-Step Calculation:
DIO = 45 days
DSO = 30 days
DPO = 35 days
CCC =45+30-35 =40 days
Interpretation: The retail business cycle to sell its inventory investments, which on average, takes 40 days.
Example 2: Manufacturing Business
Step-by-Step Calculation:
DIO = 60 days
DSO = 50 days
DPO = 45 days
CCC = 60+50-45 = 65 days
Interpretation: The manufacturing business’’ takes 65 days of turning over its investments into cash. It indicates a longer cash conversion period compare to 45 days of the retail business.
Recap of Key Points
Among all the efficiency ratios, the Cash Conversion Cycle is one of the most important indicators. It is the combination of DIO, DSO, and DPO which shows how fast a firm is in recovering its resources in cash.
CCCs should be closely checked by the companies and efforts should be made to manage the factor. By this way, businesses can stay healthy and lead to sustainable growth.
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CCC is crucial for small businesses as it directly impacts their liquidity and ability to reinvest in growth opportunities.
You can use the Cash Conversion Cycle formula CCC=DIO+DSO−DPO