What is Cash Conversion Cycle Formula?
Cash Conversion Cycle Formula calculates the time which the company requires for converting its inventory investment and other inputs into the cash and resultant are derived by adding Days Inventory Outstanding, Days Sales Outstanding and Days Payable Outstanding.
The cash conversion cycle basically represents a cash flow calculation that intends to determine the time taken by a company to convert its investment in inventory and other similar resource inputs into cash. In other words, the calculation of the cash conversion cycle determines how long cash remains invested in the form of inventory before the inventory is sold off and cash is collected from the customers. It is also known as Net Operating Cycle.
The cash conversion cycle formula has three separate parts.
- The first part is pertaining to the current inventory level and it assesses how quickly the company will be able to sell this inventory and it is represented by days inventory outstanding.
- Then, the second part is pertaining to the current sales and it asses in how much of amount of time the company is able to collect the cash from their sales and it is represented by days sales outstanding.
- The third part is the current outstanding payables and it represents by when the company will have to pay off its vendors and it is represented by days payables outstanding.
Mathematically, the formula of the cash conversion cycle is represented as,
The formula for calculation of the cash conversion cycle is very simple as all the required information is easily available in the balance sheet and the income statement and it can be derived by using the following four steps:
Step 1: Firstly, determine the average inventory during the year which can be calculated as an average of opening inventory and closing inventory from the balance sheet. Then, the Cost of goods sold (COGS) can be computed from the income statement. Now, the DIO can be calculated by dividing average inventory by COGS and multiplied by 365 days.
DIO = Average Inventory / COGS * 365
Step 2: Next, determine the average accounts receivable during the year which can be calculated as the average of opening accounts receivable and closing accounts receivable from the balance sheet. Then, the net credit sales can be taken from the income statement. Now, the DSO can be calculated by dividing average accounts receivable by net credit sales and multiplied by 365 days.
DSO = Average Accounts Receivable / Net credit sales * 365
Step 3: Next, determine the average accounts payable during the year which can be calculated as an average of opening accounts payable and closing accounts payable from the balance sheet. Then, the COGS can be taken from the income statement. Now, the DPO can be calculated by dividing average accounts payable by COGS and multiplied by 365 days.
DPO = Average Accounts Payable / COGS * 365
Step 4: Finally, the calculation of the cash conversion cycle can be done by adding DIO and DSO while deducting DPO as below.
Cash Conversion Cycle = DIO + DSO – DPO
Calculation Examples of Cash Conversion Cycle
Let us consider an example of the calculation of the cash conversion cycle for a company named PQR Ltd. As per the annual report of PQR Ltd for the financial year ended on March 31, 20XX, the following information is available.
First, we will calculate the following for the calculation of the Cash Conversion Cycle.
DIO (Days Inventory Outstanding)
- DIO= ($3,000 + $5,000) ÷ 2 / $50,000 * 365
- = 29.20 days
DSO (Days Sales Outstanding)
DSO = ($6,000 + $8,000) ÷ 2 / $140,000 * 365
= 18.25 days
DPO (Days Payable Outstanding)
- DPO= ($2,000 + $4,000) ÷ 2 / $50,000 * 365
- = 21.90 days
Therefore, calculation of Cash conversion cycle will be as follows –
Cash conversion cycle = 29.20 days + 18.25 days – 21.90 days
Cash conversion cycle will be –
- = 25.55 days ~ 26 days
Cash Conversion Cycle Calculator
You can use the following calculator –
|Cash Conversion Cycle Formula =||DIO + DSO - DPO|
|0 + 0 - 0 =||0|
Relevance and Use
It is important to understand the underlying concept of the cash conversion cycle (ccc) formula as it helps to assess how efficiently a company manages its working capital. Usually, most of the companies finance their inventory instead of paying for it upfront with cash; this results in “Accounts Payable”. On the other hand, these companies sell their inventory on credit without realizing the entire cash at the time of the sale; this results in “Accounts Receivable”. Hence, cash does not remain an issue if the company is able to collect the accounts receivable and pay the accounts payable timely.
Here, the timing is of essence from the point of view of cash management and the cash conversion cycle helps in tracing the lifecycle of the cash. In short, the shorter the cash conversion cycle, the better the company is doing in terms of selling inventories and recovering cash from the creditors while paying off the suppliers.
The cash conversion cycle can be used to compare companies in the same industry or conduct a trend analysis to assess its own performance across years. Comparison of a company’s cash conversion cycle to its competitors can be helpful to determine if the company is operating normally vis-à-vis other players in the industry. In addition, comparing a company’s current cash conversion cycle to its previous year’s cash conversion cycle can be helpful in drawing a conclusion that whether its working capital management is on the path of improvement or not.
This has been a guide to Cash Conversion Cycle Formula. Here we discuss how to calculate Cash Conversion Cycle using practical example and downloadable excel template. You can learn more about financial analysis from the following articles –