Understanding the Cash Conversion Cycle
What Is the Cash Conversion Cycle (CCC)?
The cash conversion cycle (CCC) is one of several measures of management effectiveness. It measures how fast a company can convert cash on hand into even more cash on hand. The CCC does this by following the cash, or the capital investment, as it is first converted into inventory and accounts payable (AP), through sales and accounts receivable (AR), and then back into cash. Generally, the lower the number for the CCC, the better it is for the company. Although it should be combined with other metrics (such as return on equity (ROE) and return on assets (ROA), the CCC can be useful when comparing close competitors because the company with the lowest CCC is often the one with superior management. Here’s how the CCC can help investors evaluate potential investments.
- The CCC is an indicator of how fast a company can convert its initial capital investment into cash.
- Companies with a low CCC are often the companies with the best management.
- The CCC should be combined with other ratios, such as ROE and ROA, and compared with industry competitors for the same period for an adequate analysis of a company’s management.
- The CCC is best applied to companies with inventories. It is not a reliable metric for consulting companies, for example.
Understanding the Cash Conversion Cycle (CCC)
The CCC is a combination of several activity ratios involving accounts receivable, accounts payable, and inventory turnover. AR and inventory are short-term assets while AP is a liability. All of these ratios are found on the balance sheet. In essence, the ratios indicate how efficiently management is using short-term assets and liabilities to generate cash. This allows an investor to gauge the company’s overall health.
How do these ratios relate to business? If a company sells what people want to buy, cash cycles through the business quickly. If management fails to realize potential sales, the CCC slows down. For instance, if too much inventory builds up, cash is tied up in goods that cannot be sold—this is detrimental to the company. To move inventory quickly, management must slash prices, possibly selling its products at a loss. If AR is poorly managed, the company may be experiencing difficulty collecting payment from customers. This is because AR is essentially a loan to the customer, so the company loses out whenever customers delay payment. The longer a company has to wait to be paid, the longer that money is unavailable for investment elsewhere. On the other hand, the company benefits by slowing down payment of AP to its suppliers because the extra time allows it to make use of the money longer.
To calculate CCC, you need several items from the financial statements:
- Revenue and cost of goods sold (COGS) from the income statement;
- Inventory at the beginning and end of the period;
- AR at the beginning and end of the period;
- AP at the beginning and end of the period; and
- The number of days in the period (year = 365 days, quarter = 90).
Inventory, AR, and AP are found on two different balance sheets. If the period is a quarter, then use the balance sheets for the quarter in question and those from the preceding period. For a yearly period, use the balance sheets for the quarter (or year-end) in question and those from the same quarter a year earlier.
This is because while the income statement covers everything that happened over a certain period, balance sheets are only snapshots of the company at a particular moment in time. For AP, for example, an analyst requires an average over the period being studied, which means that AP from both the period’s end and beginning are needed for the calculation.
With some background on calculating the CCC, here is the formula:
CCC = DIO + DSO – DPO
DIO is days inventory or how many days it takes to sell the entire inventory. The smaller the number, the better.
DIO = Average inventory/COGS per day
Average Inventory = (beginning inventory + ending inventory)/2
DSO is days sales outstanding or the number of days needed to collect on sales. DSO involves AR. While cash-only sales have a DSO of zero, people do use credit extended by the company, so this number will be positive. Again, a smaller number is better.
DSO = Average AR / Revenue per day
Average AR = (beginning AR + ending AR)/2
DPO is days payable outstanding. This metric reflects the company’s payment of its own bills or AP. If this can be maximized, the company holds onto cash longer, maximizing its investment potential. Therefore, a longer DPO is better.
DPO = Average AP/COGS per day
Average AP = (beginning AP + ending AP)/2
Notice that DIO, DSO, and DPO are all paired with the appropriate term from the income statement, either revenue or COGS. Inventory and AP are paired with COGS while AR is paired with revenue.
Let’s use a fictional example to work through. The data below are from a fictional retailer Company X’s financial statements. All numbers are in millions of dollars.
|Item||Fiscal Year 2018||Fiscal Year 2019|
|Average Inventory||(1,000 + 2,000) / 2 = 1,500|
|Average AR||(100 + 90) / 2 = 95|
|Average AP||(800 + 900) / 2 = 850|
Now, using the above formulas, the CCC is calculated:
DIO = $1,500 / ($3,000/ 365 days) = 182.5 days
DSO = $95 / ($9,000 / 365 days) = 3.9 days
DPO = $850 / ($3,000/ 365 days) = 103.4 days
CCC = 182.5 + 3.9 – 103.4 = 83 days
On its own, CCC does not mean very much. Instead, it should be used to track a company over time and to compare the company to its competitors.
When tracked over time, the CCC over several years can reveal an improving or worsening value. For instance, if for fiscal year 2018, Company X’s CCC was 90 days, then the company has shown an improvement between the ends of fiscal year 2018 and fiscal year 2019. While the change between these two years is good, a significant change in DIO, DSO, or DPO might merit more investigation, such as looking further back in time. CCC changes should be examined over several years to obtain the best sense of how things are changing.
CCC should also be calculated for the same periods for the company’s competitors. For example, for fiscal year 2019, Company X’s competitor Company Y’s CCC was 100.9 days (190 + 5 – 94.1). Compared with Company Y, Company X is doing a better job at moving inventory (lower DIO), is quicker at collecting what it is owed (lower DSO), and keeps its own money longer (higher DPO). Remember, however, that CCC should not be the only metric used to evaluate either the company or the management; ROE and ROA are also valuable tools for determining management’s effectiveness.
To make things more interesting, assume that Company X has an online retailer competitor Company Z. Company Z’s CCC for the same period is negative, coming in at -31.2 days. This means that Company Z does not pay its suppliers for the goods that it buys until after it receives payment for selling those goods. Therefore, Company Z does not need to hold much inventory and still holds onto its money for a longer period. Online retailers usually have this advantage in terms of CCC, which is another reason why CCC should never be used in isolation without other metrics.
Special Considerations for the Cash Conversion Cycle (CCC)
The CCC is one of several tools that can help to evaluate management, particularly if it is calculated for several consecutive periods and for several competitors. Decreasing or steady CCCs are a positive indicator while rising CCCs require a little more digging.
CCC is most effective when applied to retail-type companies, which have inventories that are sold to customers. Consulting businesses, software companies, and insurance companies are all examples of companies for whom this metric is meaningless.