Businesses that manufacture, assemble or resell goods often maintain inventories of materials or parts as part of regular operations. These inventories are turned into products and sold to customers either on cash or credit.
If sold on credit, the company then waits for a certain period to receive the payment from them. This entire cycle of purchasing inventory, converting it to products, extending credit services for the sale of products, and receiving the payment from its customer assesses how efficient the company’s operations and cash flow are and is therefore termed a cash conversion cycle.
Meaning of Cash Conversion Cycle
A cash cycle or cash conversion cycle is a metric for a business's working capital management to understand how many days are taken for the conversion of cash to inventory and back to cash through the process of sales.
The shorter the cycle, the lesser time the business has tied up cash in its inventory and accounts receivable.
Importance of Cash Conversion Cycle
A measure of the cash conversion cycle of a company dealing in buying and managing inventory is essential to understand the following -
Efficiency
It helps to measure how efficiently a business handles its working capital. It provides insights into the time taken to purchase inventory or other materials and the conversion of the same to cash.
It helps the company understand the duration of its cash being used in its operations.
Liquidity
Investors, shareholders, and stakeholders examine a company's cash conversion cycle to measure its liquidity and financial health.
The more liquid a business is, the quicker it can honor its financial obligations and pay off its loans.
Standing
Evaluating an organization's cash conversion cycle to that of its competitor helps to gauge its standing in the same industry.
It also showcases whether the company's working capital management is improving or declining.
Three Components of the Cash Conversion Cycle
Three components are needed to be measured to provide the length of a cash cycle.
They are:
The Formula of Cash Conversion Cycle
Cash Conversion Cycle = DIO (Days Inventory Outstanding) + DSO (Days Sale Outstanding) – DPO (Days Payable Outstanding)
DIO (Days Inventory Outstanding) = Average inventory value ÷ Cost of Goods sold x 365
Take, for example - The company ABC had $1500 worth of inventory at the beginning and $4000 at the end of the financial year of 2022 with $50,000 worth of cost of goods sold.
The DIO for ABC will then be -
($1500+$4000) ÷ 2 = 2750
2750 ÷ 50,000 x 365 = 20.075, which means that it takes ABC around 20 days to convert its inventory into sales.
DPO (Days Payable Outstanding) = Average Accounts Payable amount ÷ Cost of goods sold x 365 ABC accounted for $2000 in accounts payable at the beginning and $3000 at the end of the financial year 2022, with $50,000 worth of goods sold.
The DPO of ABC stands as - ($2000 + $3000) ÷ 2 = $2500
$2500 ÷ $50,000 x 365 = 18.25, indicating that ABC takes approximately 18 days to pay back its suppliers.
DSO (Days Sale Outstanding) = Average Accounts Receivable value ÷ Total credit Sales x 365
Company ABC reported $4000 in accounts receivable at the beginning of the year and $5000 at the end of the financial year 2022. They also declared a total credit sales of $100,000.
The DSO of ABC will then be - ($4000 + $5000) ÷ 2 = $4500 $4500 ÷ $100,000 x 365 = 16.425, which means ABC takes around 16 days to collect their receipts from their buyers.
*Merging all the calculations - * The cash conversion cycle of ABC = 20.075 + 16.425 - 18.25 => 18.25 days
ABC infers that it takes them approximately 18 days to turn inventory into sales and cash again.
Interpretation of Cash Conversion Cycle It is vital to assess an organization's cash conversion cycle to understand how efficiently it manages its working capital.
This can be inferred by looking at the time a business takes to convert its inventories into sales and cash again while repaying its suppliers. The shorter the duration, the better the company is at converting its stock into cash.
The cash conversion cycle for a year can also be compared to that in the preceding financial years to evaluate whether their working capital management is slumping or improving.
Negative Cash Conversion Cycle
A negative cash conversion cycle indicates that a company does not have its cash tied up in working capital and has greater liquidity.
It also signifies that a business takes minimal time to sell its goods and collect customer receipts compared to repaying its suppliers.
How to Reduce Cash Conversion Cycle
Following measures can effectively reduce the conversion cycle assisting businesses to efficiently increase and save on their working capital.
Optimizing Invoices
Optimizing invoices in a way that puts up all the necessary and relevant information in an easy-to-understand format for customers to quickly follow up or make payments can drastically reduce the cash conversion cycle and help businesses to maintain their working capital.
Improving Cash Flow
A firm cash flow processes and policies in place can help businesses in shorter cash conversion periods. An essential component of managing cash flow is monitoring the timing and volume of cash inflows and outflows.
Monitoring and improving cash flow systems can reduce the cash conversion cycle, improving the essential business aspect of working capital. Supply chain finance programs are created to help manage and improve cash flows, so that buyers can provide favorable payment terms to suppliers and enjoy longer credit periods.
Optimizing Inventory
It is easier and more convenient for businesses to reduce their cash conversion cycle by optimizing inventory.
Optimizing inventory can significantly assist businesses in selling their goods as soon as possible, reducing the cash conversion cycle. Inventory financing programs are designed to help with this.
Improving Cash Conversion Cycle
Taking the following measures to improve the conversion cycle can help businesses save up a lot of their working capital and improve their liquidity.
Pushing for Earlier Payments
One way for companies to have a healthy working capital is by nudging their customers to pay off invoices early. There can be actions to impose hefty fees for delayed payment, or businesses can offer certain incentives such as discounts for paying early.
Employing Real-Time Data Analytics
Fluctuations in cash flow can be very frequent, and keeping a check on it becomes crucial. Making use of real-time analytics will provide the business with accurate and essential information to take necessary action to help control the fluctuations.
Creating Easier Payment Mechanisms
Customers require certain payment mechanisms that the company may not be dabbling in, such as online payments. By creating flexible payment methods, customers will have more options for repayment and make their payments faster.
Providing Faster Deliveries
Another way for companies to improve their cash conversion cycle is by providing faster deliveries to their customers.
By doing so, the customer is nudged to pay their receipts faster and improve relations with the business.
Difference Between Operating Cycle and Cash Conversion Cycle
A company's operating cycle estimates the number of days between when it purchases the inventory and when it receives the money for the stock made through sale to its customers.
On the other hand, the cash conversion cycle measures the number of days between when it pays for the inventory bought and the time taken for the customers to repay for the inventory sold.
An operating cycle primarily focuses on how well a business operates, and a cash cycle understands how liquid or steady the company's cash flow is. The operational process comes under the broader cycle of cash conversion.
FAQs
How Many Days is a Good Cash Conversion Cycle?
A company's cash conversion cycle should be as short as possible. A company with a zero or negative cash conversion cycle signifies that it is highly liquid. However, not every business can achieve it sustainably. Therefore the American Productivity & Quality Center, also known as APQC, sets a benchmark between 30-35 days as a good cash conversion cycle.
What is a Good Cash Conversion Ratio?
An efficient or good cash conversion ratio would be exactly one. This signifies that a company is converting every dollar earned in its net income into cash during its financial year or period.
However, this ratio is rarely achievable, so companies either have a ratio higher or lower than one.
If an organization's ratio is above one, then the company has very high liquidity, and idle cash as their customers might be making earlier payments or the expenses of the company have been delayed.
In such a case, the company should find ways to invest the extra cash into growth and investment purposes. However, if a company's cash conversion ratio is less than one, it indicates that it cannot convert all its sales into cash and has liquidity issues.
How Does Inventory Turnover Affect the Cash Conversion Cycle?
An inventory turnover calculates how fast a company's inventory is sold, used, or restocked. It assesses whether the company has extra inventory compared to its sales.
If the inventory turnover of a company is good, then the cash conversion cycle of a company is low, which indicates that the company is achieving its operational efficiency and has a good working capital management system.