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What is a Cash Conversion Cycle?
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What Is Cash Conversion Cycle
The cash conversion cycle refers to the amount of time it takes for a company to convert an asset, investment, or resource into cash.
In other words, by measuring the cash conversion cycle, a company’s looking to see how long every dollar of investment into the business is tied up until it is converted into cash.
Cash conversion cycle looks at how long it takes for a company to sell its inventory, how long it takes the company to collect its accounts receivable, and how long it takes for the company to pay for its accounts payable.
The cash conversion cycle metric is typically used by companies that carry inventory and need to properly manage it to ensure the business remains profitable.
The lower the cash conversion cycle, the more efficient the company is managed.
On the other hand, the longer the cash conversion cycle, the less efficient the company is being managed and we should look into the reasons why the company’s cash conversion cycle is not where it should be.
Keep ready as I will break down the cash conversion cycle formula and go over an example to better illustrate the concept.
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Why Is Cash Conversion Cycle Is Important
The cash conversion cycle is an important metric to assess a company’s operating efficiency, particularly for companies that depend on the proper management of their inventory.
This measure allows a company to see how long it takes for their investment into the business will lead to cash following the sale of their goods and services.
In essence, a company that can better manage its inventory can achieve higher profitability.
The faster a company can sell its inventory and turn the sales into cash, the more it can reinvest in the business to produce more goods and services.
The cash conversion cycle evaluates three important elements of a business: inventory, sales, and payables.
A company can generate sales and receive cash or sell on credit.
It can also purchase inventory cash or on credit.
In the end, what’s important for a company is to be able to realize the cash from its sales to pay off its payables.
Ultimately, the cash conversion cycle tells you how quickly is a company able to turn its investments in the business into cash or returns.
Cash conversion cycle is used by many analysts, investors, and company management to assess both its operational efficiency and liquidity risk.
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Cash Conversion Cycle Formula
The cash conversion cycle can be calculated using the following formula:
Cash Conversion Cycle = Days Inventory Outstanding + Days Sales Outstanding – Days Payable Outstanding
Days Inventory Outstanding and Days Sales Outstanding provide a measure of how long it takes for cash to flow into the business while Days Payable Outstanding measures the cash flowing out.
To calculate Days Inventory Outstanding, you’ll need to use the following formula:
Days Inventory Outstanding = (Average Inventory / Cost of Goods Sold) X 365
To calculate Days Sales Outstanding, you’ll need to use the following formula:
Days Sales Outstanding = Average Accounts Receivable / Revenue Per Day
And to calculate Days Payable Outstanding, you’ll need to use the following formula:
Days Payable Outstanding = Average Accounts Payable / Costs of Goods Sold Per Day
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Cash Conversion Cycle Interpretation
The cash conversion cycle provides two key pieces of information to company managers, investors, and analysts: operating efficiency measure and liquidity risk.
For a company to generate more sales and increase profits, it must be able to produce more and reinvest more into its business.
The faster a company is able to go from the starting point of investment in the business and generate a return on that investment by getting cash following a sale, the more a company can scale.
The cash conversion cycle follows a company’s cash lifecycle from the moment cash is invested in purchasing inventory all the way to the moment cash is received following the sale of its goods.
The faster a company can have a dollar of cash invested in inventory turned into a dollar of cash received following a sale, the better it is for the company.
The cash conversion cycle also provides useful insights into the company’s liquidity and financial health.
If a company is purchasing inventory on credit and selling on credit, it will soon face liquidity issues as it is not collecting cash on its sales and it is borrowing money to finance its inventory.
On the other hand, a company that is able to sell its goods and self-fund the purchase of its inventory is in a much better financial position.
When a company’s cash conversion cycle is steady or reducing, it’s a good sign.
However, if a company’s cash conversion cycle is getting longer, the company may face liquidity issues in the long run.
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Cash Conversion Cycle Example
Let’s look at an example of cash conversion cycle to better illustrate the concept.
Let’s assume that Company ABC has the following financial characteristics:
- Average inventory: $10,000
- Cost of goods sold: $50,000
- Average Accounts Receivable: $15,000
- Total Credit Sales: $150,000
- Average Payable Outstanding: $5,000
The company’s Days Inventory Outstanding is ($10,000 / $50,000) X 365 = 73.
The company’s Days Sales Outstanding is ($15,000 / $350,000) X 365 = 15.6.
The company’s Days Payable Outstanding is ($5,000 / $50,000) X 365 = 36.5.
The cash conversion cycle is therefore 73 + 15.6 – 36.5 = 52.1.
The company takes 52 days to turn its investment into its inventory back into cash.
This figure should be compared to other companies in the same industry along with historical figures to see if this company is on par, doing better, or worse.
The better a company’s cash conversion cycle, the better the company is managing its working capital to earn a profit.
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Cash Conversion Cycle FAQ
What is a good cash conversion cycle?
Just like many other financial metrics, you’ll need to assess the cash conversion cycle of a company in relation to its own historical performance, its peers, and the nature of its business.
To start with, a shorter cash conversion cycle is better.
However, what is a good cash conversion cycle for one company does not mean it’s good for another.
If a company’s cash conversion cycle is longer than its competitors and it’s getting longer as the years go by, it means that the company’s operating efficiency is gradually getting worse.
On the flip side, if the cash conversion cycle is stable or getting short and it is shorter than the competitors, then the company is in a better position.
Can the cash conversion cycle be negative?
Yes, it’s possible for the cash conversion cycle to be negative.
Although in most cases, cash conversion cycle is a positive figure, it can turn out to be negative if the company is able to quickly sell its inventory, collect its receivables very fast, and pay for its payables later.
Companies that have negative cash conversion cycles are seen as highly efficient companies.
What are the elements of cash conversion cycle?
The three main elements of a cash conversion cycle are days inventory outstanding, days sales outstanding, and days payable outstanding.
Days inventory outstanding and sales outstanding measure cash inflows whereas days payable outstanding measures cash outflows.
Takeaways
So there you have it folks!
What is cash conversion cycle?
In a nutshell, the cash conversion cycle is a financial metric allowing you to calculate how long it takes for a company to convert its cash investments into inventory back to cash.
The company will typically invest its cash into building up an inventory, generating a sale, and collecting cash.
This cycle is called the cash conversion cycle where the cycle starts with the use of cash for resources, components, raw materials, and other goods to produce goods and it ends when the customer pays the company following a sale.
You can calculate the cash conversion cycle by taking your Days Inventory Outstanding, plus Days Sales Oustanding, minus Days Payable Outstanding.
The shorter the cash conversion cycle, the better the company’s working capital is managed and the lower its liquidity risk.
Now that you know what cash conversion cycle is and how it works, good luck with your research!
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