Definition of the topic: Cash Conversion Cycle measures the time (in days) a company takes to collect the cash from inventory sales. It considers the time taken to sell the inventories, get the receivables, and pay bills without penalty.
Features or Characteristics of the Cash Conversion Cycle:
- It is a measure of how effectively the company manages working capital.
- It has three components: Days Payable Outstanding, Days Sales Outstanding, and Days Inventory Outstanding.
- The cash conversion cycle is affected by the credit allowed by the company and the collection period of the company.
- The shorter is the cash conversion cycle, the better is the performance of the company.
- A longer cash conversion cycle indicates insolvency for companies, as it means that the company takes a long time to generate cash.
The following steps are involved in calculations of the Cash Conversion Cycle –
- First, you need to calculate DIO, i.e., Days inventory outstanding. It is the number of days required to sell inventories. DIO = Average inventories/ cost of inventories sold per day.
- Now you have to calculate DSO, i.e., Days Sales Outstanding. It is the number of days required to collect sales. DSO = Average accounts receivables/Revenue collected per day
- Then it would be best if you calculated DPO, i.e., Days payable outstanding. It refers to the Days Company takes to pay its bills. DPO = Average accounts payable/cost of goods sold per day.
- Now you can calculate CCC using the formula the Cash Conversion Cycle =DIO+DSO-DPO.
Pros and Cons of a Positive Cash Conversion Cycle: Positive, the Cash Conversion Cycle, means that the company takes less time to pay its bills than sell inventories and generate cash.
- It means customers have more time to pay their bills to the company, and hence it will attract more customers from the market.
- Creditors will be easily accessible due to a short payable period. They will readily sell their goods to the company on credit.
- It can lead to an increase in working capital due to the rise in sales, and a substantial collection period may lead to short-term loans.
- There might be customers who won’t pay the debts on time and may lead to bad debts.
- An increase in demand of product might lead to a shortage of goods or inventories and increase the risk of unfulfilled orders.
Pros and Cons of a Negative Cash Conversion Cycle: Negative the Cash Conversion Cycle means that the company takes more time to pay its bills than sell inventories and generate cash.
- They can quickly pay the creditors after getting money from the customers.
- Due to long payable periods, indirect working capital is provided, so no short-term loans are required.
- Creditors might not be easily accessible due to a long payable period.
- The company might lose customers due to short credit to customers.
The cash conversion cycle plays a vital role in determining the health of a company as it measures how effectively the company’s working capital is used. A company that has a shorter cash conversion cycle outperforms the ones with long cash conversion cycles.