{"id":25312,"date":"2023-07-26T17:36:00","date_gmt":"2023-07-26T17:36:00","guid":{"rendered":"https:\/\/businessyield.com\/?p=25312"},"modified":"2023-09-03T02:44:01","modified_gmt":"2023-09-03T02:44:01","slug":"ccc","status":"publish","type":"post","link":"https:\/\/businessyield.com\/terms\/ccc\/","title":{"rendered":"CCC: Cash Conversion Cycle Simplified!!! [+Practical Examples]","gt_translate_keys":[{"key":"rendered","format":"text"}]},"content":{"rendered":"\n

What is CCC? <\/span><\/h2>\n\n\n\n

The cash conversion cycle (CCC) \u2013 often known as the cash cycle \u2013 is a working capital indicator that measures how long it takes for a company to convert cash into inventory and then back into cash through the sales process. The lower the CCC, the less time a company’s cash is locked up in accounts receivable and inventories<\/a>.<\/p>\n\n\n\n

Basically, the CCC is a crucial indicator for companies that buy and manage inventory. This is because it indicates both operational and financial efficiency. It should, however, not be seen in isolation, but rather in conjunction with other financial indicators such as return on equity.<\/a> It’s also worth noting that CCC isn’t a major consideration for all businesses, as not every company will have physical inventory.<\/p>\n\n\n\n

Understanding the Cash Conversion Cycle (CCC)<\/h2>\n\n\n\n

The CCC is made up of multiple activity ratios that include accounts receivable, payable<\/a>, and inventory turnover. AP is a liability, while AR and inventory are short-term assets. The balance sheet contains all of these ratios. In reality, the ratios show how well management is generating cash from short-term assets and liabilities. An investor can use this information to assess the company’s overall health.<\/p>\n\n\n\n

But then, you may ask, “What are the business implications of these ratios?” <\/p>\n\n\n\n

Cash flows fast through a firm if it sells what customers desire to buy. The CCC slows down if management fails to realize potential sales. For example, if too much inventory accumulates, cash is locked up in things that cannot be sold, which is bad for business. To move inventory rapidly, management must lower prices, perhaps losing money on the sale of its items. <\/p>\n\n\n

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Source: CFI<\/em><\/figcaption><\/figure><\/div>\n\n\n

If AR isn’t well-managed, the organization may have trouble collecting payments from customers. And because AR is essentially a loan to the consumer, the company loses money when they don’t pay on time. The longer a corporation has to wait for payment, the less money is available for further investments. Slowing down AP payment to suppliers, on the other hand, benefits the company because of the extra time it allows to put the money to better use.<\/p>\n\n\n\n

The Cash Conversion Cycle’s Elements<\/h2>\n\n\n\n

Calculating the CCC may be daunting at first, but once you grasp the elements involved, it becomes much easier.<\/p>\n\n\n\n

To make the calculations, you’ll need to consult your financial statements, such as the balance sheet<\/a> and income statement<\/a>. Meanwhile, the three major elements of the cash conversion cycle include, Days Inventory Outstanding, Days Sales Outstanding, and Days Payable Outstanding.<\/p>\n\n\n\n

Days Inventory Outstanding <\/h3>\n\n\n\n

Days Inventory Outstanding is the first part of the equation (DIO). This is the average time for inventory to be converted into final products and sold.<\/p>\n\n\n\n

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DIO = (Average Inventory \u00f7 Cost of Goods Sold) x 365<\/strong><\/em><\/p>\n<\/blockquote>\n\n\n\n

But then the average inventory (in value) for the period will be an addition of the beginning inventory value and ending inventory value; then dividing the sum by 2<\/p>\n\n\n\n

Mathematically;<\/p>\n\n\n\n

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(Beginning Inventory + Ending Inventory) \u00f7 2<\/strong><\/em><\/p>\n<\/blockquote>\n\n\n\n

The cost of products sold is calculated as follows:<\/p>\n\n\n\n

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Ending Inventory = Beginning Inventory + Purchases.<\/em><\/strong><\/p>\n<\/blockquote>\n\n\n\n

Days Sales Outstanding <\/h3>\n\n\n\n

Days Sales Outstanding (DSO) is the average number of days it takes for you to retrieve your accounts receivable (money owing to you).<\/p>\n\n\n\n

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DSO = (Net Credit Sales + Accounts Receivable) x 365<\/em><\/strong><\/p>\n<\/blockquote>\n\n\n\n

The average of your beginning and ending receivables is your accounts receivable for this section.<\/p>\n\n\n\n

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(Beginning Receivables + Ending Receivables) \u00f7 2<\/strong><\/em><\/p>\n<\/blockquote>\n\n\n\n

Days Payable Outstanding <\/h3>\n\n\n\n

Days Payable Outstanding (DPO) is the average time it takes a firm to purchase goods and services from its suppliers on accounts payable (your company owes money) and pay for them.<\/p>\n\n\n\n

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DPO = Ending Accounts Payable \u00f7 (Cost of Goods Sold \u00f7 365)<\/strong><\/em><\/p>\n<\/blockquote>\n\n\n\n

In this section, the accounts payable are:<\/p>\n\n\n\n

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(Beginning Payable + Ending Payable) \u00f7 2.<\/em><\/strong><\/p>\n<\/blockquote>\n\n\n\n

What Constitutes a Satisfactory Cash Conversion Cycle?<\/h2>\n\n\n\n

A short cash conversion period is ideal. <\/p>\n\n\n\n

If your CCC is low or (better still) negative, your working capital is not locked up for long periods of time, and your company has more liquidity. Many online businesses have low or negative CCCs because they drop-ship instead of retaining inventory. They receive immediate payment when customers buy things, and do not have to pay for inventory until customers have already paid them.<\/p>\n\n\n\n

On the other hand, you don’t want your CCC to be too high if it’s a positive number. A positive CCC indicates how many days your company’s working capital is stranded as it waits for accounts receivable to be paid. If you sell things on credit and your customers need 30, 60, or even 90 days to pay you, you may have a high CCC.<\/p>\n\n\n\n

Read Also: SHORT TERM DEBT: Definition, Examples, and Debt financing<\/a><\/h5>\n\n\n\n

However, you can shorten your company’s cash conversion cycle in a number of ways. <\/p>\n\n\n\n

This is by making your accounts receivable procedure as efficient as possible, for starters. Remove any needless jargon from your bills and be explicit about what you’re billing for and the terms you’re requesting. <\/p>\n\n\n\n

For the most part, you’ll receive payments faster if the buyer understands the invoice quickly. You can also reduce the CCC by requesting advance payments or offering a discount for paying early. Finally, staying on top of late payments by following up as soon as a payment is due is a good idea.<\/p>\n\n\n\n

What Role Does Cash Flow Play?<\/h2>\n\n\n\n

The cash conversion cycle is a cash flow formula that determines how long it takes for your company to convert inventories and other assets into cash. To put it another way, the cash-to-cash cycle time is the interval between when you pay for inventory and when customers pay to replenish your company’s cash flow. Keeping cash flow positive in industries with high inventory and material demands, such as construction, can be the difference between taking on new clients and turning them away.<\/p>\n\n\n\n

The conversion cycle calculation determines how long a company’s cash is held until it is recovered from clients and customers. Keeping a careful eye on the company’s CCC might help you keep track of its total finances as money comes in and goes out. If you’re confused about the differences between cash flow and profit, keep in mind that they’re not the same thing. While profit is the amount of money left over after a company’s expenses are paid at a fixed point in time, cash flow is flexible. It shows how much money is coming in and going out of a company.<\/p>\n\n\n\n

What’s the Difference Between a Cash Conversion Cycle and an Operating Cycle?<\/h2>\n\n\n\n

Obviously, there’s a big difference between a cash conversion cycle and an operating cycle. <\/p>\n\n\n\n

Simply put, an operating cycle is the number of days between when you buy goods and when clients pay for them. The cash conversion cycle is the number of days it takes for you to pay for inventory and receive payment from your clients.<\/p>\n\n\n\n

Why is the Cash Conversion Cycle so important?<\/h2>\n\n\n\n

There are various reasons why keeping track of your cash conversion cycle is critical. <\/p>\n\n\n\n

For starters, investors, lenders, and other sources of capital frequently examine a company’s cash conversion cycle to gauge its financial health and, in particular, its liquidity. A company’s liquidity determines how readily it can repay a corporate loan, satisfy other financial obligations, and invest in growth. Furthermore, the cash conversion cycle is particularly useful for evaluating inventory-based enterprises like shops. However, it is not the only financial criterion used by lenders; they often mix it with other factors before determining whether or not to give out the loan.<\/p>\n\n\n\n

Suppliers may consider your CCC while considering whether or not to grant credit to your business. They are often concerned that you may not be able to pay them on time if your company lacks appropriate liquidity.<\/p>\n\n\n\n

Read Also: Debt To Equity Ratio: Explained!!!, Formula, Calculations, Examples<\/a><\/h5>\n\n\n\n

On the other hand, you should be concerned about the cash conversion cycle as well. <\/p>\n\n\n\n

Like we earlier mentioned; a low CCC suggests that you’re doing a good job of converting inventory to cash and that your firm is running well. If your CCC is too high, however, it could indicate operational concerns, a lack of demand for your goods, or a shrinking market niche. So if your CCC isn’t to your liking, determine what’s wrong and take steps to fix it, such as increasing your invoice collection efforts.<\/p>\n\n\n\n

Finally, when determining how much money you need to borrow, your cash conversion cycle is a crucial factor to consider. Understanding your CCC and, as a result, your company’s liquidity, can assist you in determining how much cash you can request from a lender.<\/p>\n\n\n\n

The Formula for CCC <\/h2>\n\n\n\n

Since CCC includes calculating the net aggregate time involved over the three stages of the cash conversion lifecycle mentioned above, the mathematical formula for CCC is:<\/p>\n\n\n\n

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\u200bCCC<\/em>=DIO<\/em>+DSO<\/em>\u2212DPO<\/em><\/p>\n\n\n\n

where:<\/strong> DIO<\/em>=Days of inventory outstanding(also known as days sales of inventory)<\/p>\n\n\n\n

DSO<\/em>=Days sales outstanding<\/p>\n\n\n\n

DPO<\/em>=Days payables outstanding<\/p>\n<\/blockquote>\n\n\n\n

DIO and DSO represent \u200bcash inflows, whereas DPO represents cash outflows. <\/p>\n\n\n\n

As a result, DPO is the sole negative number in the equation. Another way to look at the formula is that DIO and DSO are tied to inventory and accounts receivable, which are both considered short-term assets and are assumed to be positive. DPO is associated with accounts payable, which is a liability and consequently a negative number.<\/p>\n\n\n\n

CCC Calculation<\/h2>\n\n\n\n

The cash conversion cycle of a business is divided into three parts. Several items from the financial accounts are required to compute CCC:<\/p>\n\n\n\n