If you're running a retail business or if your business deals with any kind of inventory, smart management of your company's cash flow is crucial to your business' financial health. One of the key metrics you can use to analyze your cash flow is called the cash conversion cycle (CCC). By calculating this cycle and analyzing it over time, you'll be able to determine whether your company is using its working capital in the most efficient way.
Defining the Cycle
The cash conversion cycle is a measure of the total number of days it takes to sell your inventory, collect the money due to your company (also known as accounts receivable, or simply receivables) and pay your own bills (aka accounts payable or payables). (Study up on accounts receivable and accounts payable.)
The "cycle" part comes in when we consider that the company uses its assets (cash to purchase inventory in the first place, then experiences an influx of cash by selling goods. Finally, the company uses this cash to pay its own bills, thus completing the cycle.
Calculating the Cycle
In order to calculate the CCC, you're going to need some information from your financial statements. From your income statement, you will need to know your revenue for the period you're analyzing (ex: a financial quarter) and the cost of goods sold (COGS) for the same period. From your balance sheet, you will need the total inventory, accounts receivable, and accounts payable at the beginning and end of the period.
Finally, you will need the total number of days in the period you're analyzing (ex: 90 days if you're looking at a financial quarter).
Now you're ready to calculate the CCC using the following formula:
CCC = Days inventory outstanding + Days sales outstanding - Days payable outstanding
The days inventory outstanding is the number of days it takes to sell all of your inventory. This is also known as the inventory conversion period, i.e. the time it takes to convert inventory into sellable goods and then sell those goods. You can find this number by dividing the average inventory (found by taking the inventory at the beginning of the period, adding the inventory at the end of the period, and dividing that total by 2) and dividing that number by the COGS per day.
To get days sales outstanding (aka the average collection period), take the average number of days it takes to collect payment on sales of goods, and divide this number by the revenue per day. If you only accept cash payments, the number of days will be 0, but if you take payment on credit, the number will be larger.
Days payable outstanding is the average number of days it takes for your company to pay its own bills/accounts payable. Also called the payables deferral period, this number is found by dividing the average accounts payable by COGS per day.
Improving Your CCC
Now that you're equipped with the formula to calculate your cash conversion cycle, you're able to look critically at the results over different periods of time and start figuring out how to improve your business' cycle. As we mentioned before, the CCC is a way to measure how well your company's cash flow is being managed, and it's also an indicator of your business' liquidity, (i.e., how quickly assets can be converted into cash). All of this information forms a vital part of the picture of your company's overall financial health.
Generally speaking, you want your cash conversion cycle to be as short as possible. A shorter cycle means that your company's cash is tied up over a shorter length of time, because it takes fewer days to convert inventory and receivables into cash, while also making sure the company is paying its own bills on time so as not to incur penalties.
So how can you shorten your cash conversion cycle? One way is to sell more goods and collect payment on them sooner, which will shorten both the days inventory outstanding and days sales outstanding. You can also stretch out your payables deferral period, as long as you don't get charged late fees in the process. Improving your revenues where possible will also help.
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