Cash Conversion Cycle

What is the Cash Conversion Cycle?

Cash conversion cycle, also known as Net Operating Cycle, measures the time which the company takes for converting its inventory and other inputs into the cash and considers the time required for selling the inventory, time required for collecting receivables, and the time company gets for paying its bills

Cash Conversion Cycle

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For eg:
Source: Cash Conversion Cycle (wallstreetmojo.com)

We have Amazon and Ford’s Cash Conversion Cycle (CCC) in the above chart. And from this chart, it’s clear that Ford Cash Cycle is 261 days, while Amazon’s Cash Cycle is negative! Which company is doing better? Does it matter for a company?  If it matters, how do we calculate it?

If you look at the term, you would understand that it has everything to do with turning cash into something else and how much time it takes to turn that “something else” into cash again. In simple terms, it means how long cash is tied up in inventory before the inventory is sold and cash is collected from the customers.

Think about a simple example to understand this. Suppose you go to the market and buy gold and keep it until you can sell that again in the market and receive cash. The time since when you go to the market and collect gold to the time you receive the cash to sell the gold again is called the cash conversion cycle.

It is one of the best ways to check the sales efficiency of the company. It helps the firm know how quickly they can buy, sell, and receive cash. It is also called a cash cycle.

Cash Conversion Cycle Formula

Let’s have a look at the formula, and then we will explain the formula in detail.

Cash Conversion cycle Formula= Days Inventory Outstanding (DIO) + Days Sales Outstanding (DSO) – Days Payable Outstanding (DPO)

Now let’s understand each of them.

DIO stands for Days Inventory OutstandingDays Inventory OutstandingDays Inventory Outstanding refers to the financial ratio that calculates the average number of days of inventory held by the company before selling it to the customers, providing a clear picture of the cost of holding and potential reasons for the delay in the inventory sale.read more. If we break days inventory outstanding further, we would need to divide inventory by cost of sales and multiply by 365 days.

Days Inventory Outstanding (DIO) = Inventory / Cost of Sales * 365

Days Inventory Outstanding signifies the total number of days taken for the company to convert the inventory into the finished product and complete the sales process. (also look at Inventory Valuation)

Later in the example section, we will take DIO and illustrate it with an example.

DSO stands for Days Sales OutstandingDays Sales OutstandingDays sales outstanding portrays the company's efficiency to recover its credit sales bills from the debtors. The number of days debtors took to make the payment is computed by multiplying the fraction of accounts receivables to net credit sales with 365 days.read more. How would we calculate it? Here’s how. Take accounts receivableAccounts ReceivableAccounts receivables refer to the amount due on the customers for the credit sales of the products or services made by the company to them. It appears as a current asset in the corporate balance sheet.read more. Divide it by net credit sales. And then multiply by 365 days.

Days Sales Outstanding (DSO) = Accounts Receivable / Net Credit Sales * 365

We will see an example of DSO in the example section.

DPO stands for Days Payable OutstandingDays Payable OutstandingDays Payable Outstanding (DPO) is the average number of days taken by a business to settle their payable accounts. DPO basically indicates the credit terms of a business with its creditors. read more. We need to calculate Days Payable Outstanding by taking accounts payable into account, and then we need to divide it by Cost of Sales and then multiply it with 365 days.

Days Sales Oustanding signifies the number of days taken to convert the Accounts Receivables to Cash. You can think of this as the credit periodCredit PeriodCredit period refers to the duration of time that a seller gives the buyer to pay off the amount of the product that he or she purchased from the seller. It consists of three components - credit analysis, credit/sales terms and collection policy.read more given to your clients.

Days Payable Outstanding (DPO) = Accounts Payable / Cost of Sales * 365

Now you may wonder why we are adding DIO and DSO and deducting DPO. Here’s why. In the case of DIO and DSO, the firm would about get an inflow of cash, whereas, in the case of DPO, the firm needs to pay out cash.

Days Payable Oustanding is the credit period that you get from your suppliers.

Interpretation of the Cash Conversion Cycle

This ratio explains that how much time it takes for a firm to receive cash from customers after it has invested into purchasing the inventory. When the inventory is purchased, the cash is not immediately paid. That means the purchase is made on credit, which gives the firm some time to market the inventory to the customers. During this time, the firm makes sales, but don’t receive the cash yet.

Then the day comes when the firm needs to pay for the purchase it has made earlier. And after some time, the firm receives the cash from the customers on the due date.

Now, it may seem a bit confusing, but if we use a date, it would be easier to understand. Let’s say that the due date for payment for the purchase is 1st April. And the date of receiving the cash from customers is on 15th April. That means the Cash Cycle would be the difference between the date of payment and the day of receiving cash. And here it is, 14 days.

If CCC is shorter, it’s good for a firm; because then the firm can quickly buy, sell, and receive cash from customers and vice versa.

Cash Conversion Cycle Example

First, we will take 3 examples to illustrate DIO, DSO, and DPO. And then, we will take a detailed example to illustrate the whole cash conversion cycle.

Let’s get started.

Days Inventory Outstanding Calculation Example

We have the following information about Company A and Company B.

In US $Company ACompany B
Inventory10,0005,000
Cost of Sales50,00040,000

We have been given the inventory and cost of sales for both of these companies. So we will calculate the Days Inventory Outstanding by using the formula.

For Company A, the inventory is $10,000, and the cost of sales is $50,000. And we assume that there are 365 days in a year.

So, days inventory outstanding (DIO) for Company A is –

10,000/50,000 *365 = 73 days

For Company B, the inventory is $5,000, and the cost of sales is $40,000. And we assume that there are 365 days in a year.

So, days inventory outstanding (DIO) for Company B is –

5,000/40,000 *365 = 45 days

If we compare the DIO of both the companies, we would see that Company B is in a good position in terms of converting its inventory in cash because it can convert its inventory in cash much sooner than Company A.

Days Sales Outstanding Calculation Example

We have the following information about Company A and Company B.

In US $Company ACompany B
Accounts Receivable8,00010,000
Net Credit Sales50,00040,000 

We have been given the accounts receivable and net credit salesCredit SalesCredit Sales is a transaction type in which the customers/buyers are allowed to pay up for the bought item later on instead of paying at the exact time of purchase. It gives them the required time to collect money & make the payment. read more for both of these companies. So we will calculate the Days Sales Outstanding by using the formula.

For Company A, the accounts receivable is $8,000, and net credit salesNet Credit SalesNet credit sales is the revenue generated from goods or services sold on credit excluding the sales discount, sales allowance and sales return. It even amounts to the accounts receivables for a certain accounting period.read more are $50,000. And we assume that there are 365 days in a year.

So, days sales outstanding (DSO) for Company A is –

8,000/50,000 *365 = 58.4 days

For Company B, the accounts receivable is $10,000, and net credit sales are $40,000. And we assume that there are 365 days in a year.

So, days sales outstanding (DSO) for Company B is –

10,000/40,000 *365 = 91.25 days

If we compare the DSO of both the companies, we would see that Company A is in a good position in terms of converting its accounts receivable in cash because it can convert it into cash much sooner than Company B.

Days Payables Outstanding Calculation Example

We have the following information about Company A and Company B.

In US $Company ACompany B
Accounts Payables11,0009,000
Cost of Sales54,00033,000 

We have been given the accounts payables and the cost of sales for both of these companies. So we will calculate the Days Payables Outstanding by using the formula.

For Company A, the accounts payables are $11,000, and the cost of sales is $54,000. And we assume that there are 365 days in a year.

So, days payables outstanding (DPO) for Company A is –

11,000/54,000 *365 = 74.35 days

For Company B, the accounts payables are $9,000, and the cost of sales is $33,000. And we assume that there are 365 days in a year.

So, days payables outstanding (DPO) for Company B is –

9,000/33,000 *365 = 99.55 days

Now which company has better DPO? There are two things we need to consider here. First, if DPO is more, the company has more cash handy, but if you keep the money for a long time, you may miss out on the discount. Second, if DPO is less, you won’t be having more free cash flow and working capital; but you would be able to pay your creditor faster, which will help you build the relationship and also avail the discount.

So now you can understand that the consequence of DPO actually depends on the situation the firm is in.

Cash Conversion Cycle Calculation Example

Let’s take a complete example to find out the Cash Cycle.

We would be taking two companies, and here are the details below.

In US $Company ACompany B
Inventory30005000
Net Credit Sales40,00050,000
Accounts Receivable5,0006,000
Accounts Payables4,0003,000
Cost of Sales54,00033,000

Now let’s calculate each of the portions to find out the Cash Cycle.

First, let’s find out Days Inventory Outstanding (DIO) for both the companies.

In US $Company ACompany B
Inventory3,0005,000
Cost of Sales54,00033,000

So the Days Inventory Outstanding (DIO) would be –

In US $Company ACompany B
DIO (Break-up)3,000/54,000*3655,000/33,000*365
DIO20 days (approx.)55 days (approx.)

Now let’s calculate Days Sales Outstanding (DSO).

In US $Company ACompany B
Accounts Receivables5,0006,000
Net Credit Sales40,00050,000

So the Days Sales Outstanding (DIO) would be –

In US $Company ACompany B
DSO (Break-up)5,000/40,000*3656,000/50,000*365
DSO46 days (approx.)44 days (approx.)

Now let’s calculate the final portion before calculating the Cash Cycle, and that is Days Payables Outstanding (DPO).

In US $Company ACompany B
Accounts Payables4,0003,000
Cost of Sales54,00033,000

So the Days Payables Outstanding (DPO) would be –

In US $Company ACompany B
DPO (Break-up)4,000/54,000*3653,000/33,000*365
DPO27 days (approx.)33 days (approx.)

Now, let’s find out the Cash Cycle for both of the companies.

In US $Company ACompany B
DIO20 days55 days
DSO46 days44 days
DPO27 days33 days
CCC (Break-up)20+46-2755+44-33
Cash Conversion Cycle39 days66 days

We now have the cash cycle for both of the companies. And if we imagine that these companies are from the same industry and if other things remain constant, then in a matter of comparison, Company A has a better hold on their cash cycle than Company B.

As a note, you should remember that when you add DIO and DSO, it’s called the operating cycleOperating CycleThe operating cycle of a company, also known as the cash cycle, is an activity ratio that measures the average time required to convert the company's inventories into cash.read more. And after deducting the DPO, you may find a negative Cash Cycle. Negative Cash Cycle means the firm is getting paid by their customers long before they ever pay their suppliers.

Apple Cash Cycle (Negative)

Let us have a look at the Cash Cycle of Apple. We note that the cash cycle of Apple is Negative.

Apple Negative Cash Conversion Cycle

source: ycharts

Negative Cash Cycle Examples

Like Apple, there are many companies that have negative cash cycle. Below is the list of top companies with the Negative Cash Cycle.

S. NoNameCash Cycle (days)Market Cap ($ million)
1China Mobile                                                        (653.90)                                             231,209
2British American Tobacco                                                        (107.20)                                             116,104
3AstraZeneca                                                        (674.84)                                               70,638
4EOG Resources                                                        (217.86)                                               58,188
5Telefonica                                                        (217.51)                                               48,060
6TransCanada                                                        (260.07)                                               41,412
7Orange                                                        (106.46)                                               41,311
8Anadarko Petroleum                                                        (246.41)                                               39,347
9BT Group                                                        (754.76)                                               38,570
10China Telecom Corp                                                        (392.12)                                               38,556
11Pioneer Natural Resources                                                        (113.37)                                               31,201
12WPP                                                    (1,501.56)                                               30,728
13Telekomunikasi Indonesia                                                        (142.18)                                               29,213
14China Unicom                                                        (768.24)                                               28,593
15Incyte                                                        (294.33)                                               22,670
16Telecom Italia                                                        (194.34)                                               19,087
17Continental Resources                                                        (577.48)                                               17,964
18Noble Energy                                                        (234.43)                                               17,377
19Telecom Italia                                                        (194.34)                                               15,520
20Marathon Oil                                                        (137.49)                                               14,597

source: ycharts

  • WPP has a cash cycle of – 4 years.
  • China Mobile has a cash cycle of -1.8 years.
  • BT Group has a cash cycle Ratio of -2.07 years.

Aaron’s Cash Conversion Cycle – Increasing

Earlier, we looked at examples of WPP that have a cash cycle of -4 years. Let us now take an example of Aaron’s Cash Conversion Cycle that is close to 1107 days ~ 3 years! Why is that so?

Aaron's increasing Cash Conversion Cycle

source: ycharts

Aaron engages in the sales and leaseLeaseLeasing is an arrangement in which the asset's right is transferred to another person without transferring the ownership. In simple terms, it means giving the asset on hire or rent. The person who gives the asset is “Lessor,” the person who takes the asset on rent is “Lessee.”read more ownership and specialty retailing of furniture, consumer electronics, home appliances, and accessories. Due to the holding of large amounts of inventory, Aaron’s Days Inventory Oustanding has increased continuously over the years. Since there has been not much change in Aaron’s Days Sales Oustanding or Days payables Oustanding, its cash conversion cycle has mimicked the trend of Inventory Oustanding Days.

  • Aaron Days Inventory Oustanding  ~ 1089 days;
  • Aaron Days Sales Oustanding ~ 17.60 days.
  • Aaron Days Payable Oustanding is ~ 0 days.
  • Aaron Cash Cycle = 1089 days + 17.60 days – 0 days ~  1,107 days (Cash Conversion Cycle)

Airline Industry Example

Below is the Cash Cycle Ratio of some of the Top US Airline companies.

S. NoNameCash Cycle (days)Market Cap ($ million)
1Delta Air Lines                                           (17.22)35207
2Southwest Airlines                                               (36.41)32553
3United Continental                                               (20.12)23181
4American Airlines Group                                                    5.7422423
5Ryanair Holdings                                               (16.73)21488
6Alaska Air Group                                                  13.8011599
7Gol Intelligent Airlines                                               (33.54)10466
8China Eastern Airlines                                                    5.757338
9JetBlue Airways                                               (17.90)6313
10China Southern Airlines                                                  16.805551
 Average                                                  (9.98) 

source: ycharts

We note the following –

  • An average Cash conversion ratio of Airline companies is -9.98 days (negative). Overall the airline companies collect their receivables much before they are required to pay what it owes.
  • South Western Airline has a cash conversion of -36.41 days (negative cash conversion)
  • China Southern Airlines, however, has a cash conversion cycle of 16.80 days (above the sector average). It means that China Southern Airlines is not managing its cash cycle properly.

Apparel Industry Example

Below is the Cash Conversion of some of the Top Apparel companies.

S. NoNameCash Cycle (days)Market Cap ($ million)
1TJX Companies                                                             25.9                                 49,199
2Luxottica Group                                                             26.1                                 26,019
3Ross Stores                                                             20.5                                 25,996
4L Brands                                                             31.1                                 17,037
5Gap                                                             33.1                                   9,162
6Lululemon Athletica                                                             83.7                                   9,101
7Urban Outfitters                                                             41.2                                   3,059
8American Eagle Outfitters                                                             25.4                                   2,726
9Children’s Place                                                             47.3                                   1,767
10Chico’s FAS                                                             32.4                                   1,726
 Average                                                             36.7 

source: ycharts

We note the following –

  • The average Cash conversion ratio of Apparel companies is 36.67 days.
  • Lululemon Athletica has a cash conversion cycle of 83.68 days (way above the industry average).
  • Ross Stores, however, has a cash conversion of 20.46 days ( below the industry average). It means that Ross Stores is dong much better in managing its inventory, converting receivables to cash, and probably getting a good credit period too from its suppliers of raw material.

Beverages – Soft Drink Industry

Below is the Cash Cycle of some of the Top Soft Drinks companies.

S. NoNameCash Conversion Cycle (days)Market Cap ($ million)
1Coca-Cola                                                  45.73                              179,160
2PepsiCo                                                    5.92                              150,747
3Monster Beverage                                                  59.83                                 24,346
4Dr Pepper Snapple Group                                                  25.34                                 16,850
5Embotelladora Andina                                                    9.07                                   3,498
6National Beverage                                                  30.37                                   2,467
7Cott                                                  41.70                                   1,481
8Primo Water                                                    8.18                                       391
9Reed’s                                                  29.30                                         57
10Long Island Iced Tea                                                  48.56                                         29
 Average                                                  30.40 

source: ycharts

We note the following –

  • The average Cash conversion ratio of Soft Drink companies is 30.40 days.
  • Monster Beverage has a cash conversion of 59.83 days (way above the industry average).
  • Primo Water, however, has a cash conversion cycle of 8.18 days ( below the industry average).

Oil & Gas E&P Industry

Below is the Cash Cycle of some of the Top Oil & Gas E&P companies.

S. NoNameCash Conversion Cycle (days)Market Cap ($ million)
1ConocoPhillips                                                           (14.9)                                 62,484
2EOG Resources                                                        (217.9)                                 58,188
3CNOOC                                                           (44.1)                                 56,140
4Occidental Petroleum                                                           (96.7)                                 52,867
5Anadarko Petroleum                                                        (246.4)                                 39,347
6Canadian Natural                                                             57.9                                 33,808
7Pioneer Natural Resources                                                        (113.4)                                 31,201
8Apache                                                             33.8                                 22,629
9Continental Resources                                                        (577.5)                                 17,964
10Noble Energy                                                        (234.4)                                 17,377
 Average                                                        (145.4) 

source: ycharts

We note the following –

  • The average Cash conversion ratio of Oil & Gas E&P companies is -145.36 days (negative cash cycle).
  • Canadian Natural has a cash conversion cycle of 57.90 days (way above the industry average).
  • Continental Resources, however, has a cash cycle of -577 days ( below the industry average).

Semiconductors Industry

Below is the Cash Cycle of some of the Top Semiconductor companies.

S. NoNameCash Conversion Cycle (days)Market Cap ($ million)
1Intel                                                             78.3                              173,068
2Taiwan Semiconductor                                                             58.7                              160,610
3Broadcom                                                             53.4                                 82,254
4Qualcomm                                                             30.7                                 78,254
5Texas Instruments                                                           129.7                                 76,193
6NVIDIA                                                             60.1                                 61,651
7NXP Semiconductors                                                             64.4                                 33,166
8Analog Devices                                                           116.5                                 23,273
9Skyworks Solutions                                                             89.6                                 16,920
10Linear Technology                                                           129.0                                 15,241
 Average                                                             81.0 

source: ycharts

We note the following –

  • The average Cash conversion ratio of Semiconductor companies is 81 days.
  • Texas Instruments has a cash cycle of 129.74 days (way above the industry average).
  • Qualcomm, however, has a cash cycle of 30.74 days ( below the industry average).

Steel Industry – Cash Cycle

Below is the Cash Cycle of some of the Top Steel companies.

S. NoNameCash Cycle (days)Market Cap ($ million)
1ArcelorMittal                                                             24.4                                 24,211
2Tenaris                                                           204.1                                 20,742
3POSCO                                                           105.6                                 20,294
4Nucor                                                             75.8                                 18,265
5Steel Dynamics                                                             81.5                                   8,258
6Gerdau                                                             98.1                                   6,881
7Reliance Steel & Aluminum                                                           111.5                                   5,919
8United States Steel                                                             43.5                                   5,826
9Companhia Siderurgica                                                           112.7                                   4,967
10Ternium                                                           102.3                                   4,523
 Average                                                             95.9 

source: ycharts

  • The average Cash conversion ratio of Steel companies is 95.9 days. We note the following –
  • Tenaris has a cash cycle of 204.05 days (way above the industry average).
  • ArcelorMittal, however, has a cash conversion cycle of 24.41 days ( below the industry average).

Limitations

Even if the Cash cycle is very useful to find out how fast or slow a firm can convert inventory into cash, there are few limitations that we need to pay heed to.

Cash Conversion Cycle Video

 

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In the final analysis

In the end, now you know how to calculate CCC. However, there is one thing that you should keep in mind. The cash conversion cycle should not be looked at in isolation. One should do a Ratio Analysis to completely understand the fundamentals of the company. Only then will you be able to view holistically. Another important point to note about Cash Cycle is that it should be compared with the Industry Average. With this comparison, we will know how well the company is doing with respect to its peers and whether it stands out or not.

Reader Interactions

Comments

  1. Aniefre Thomas says

    I’ve learned a lot from this blog and I wanted to thank you for you clear and concise explanations about many things myself and my peers have had questions about. These posts make me pumped to learn more and more everyday.

    One of my favorite blogs hands down!

    • Dheeraj Vaidya says

      thanks Aniefre for the appreciation. I am glad you like this blog :-)

  2. Dyrell Robinson says

    Good stuff man.
    Keep doing this. I appreciate it.

  3. Choudhary Nafees Ahmed says

    nice article… easy and best example to exlpain Days Inventory Outstanding (DIO) , Days Sales Outstanding (DSO) & Days Payable Outstanding (DPO)