Cash Conversion Cycle Explained in 60 Seconds

CFA Level 1 / Corporate Finance / CCC



CFA Cash Conversion Cycle

Cash Conversion Cycle Definition

The cash conversion cycle (CCC) measures the time from paying suppliers for materials (or inventory) to collecting the cash from the sale of goods produced from these materials (or inventory).

The CCC is one of the liquidity measures and is also called the net operating cycle.



Cash Conversion Cycle Formula

cash conversion cycle = number of days of inventory (DOH) + number of days of receivables (DSO) - number of days of payables (DPO)

Where:

  • Number of days of inventory (days of inventory on hand = DOH) is equal to the ratio of (inventory) and (cost of goods sold per day). This ratio tells us how many days on average inventory remains in the company.
  • Number of days of receivables (days sales outstanding = DSO) is equal to the ratio of (accounts receivable) and (sales on credit per day). This ratio shows how much time (how many days) we have to wait for receivables to be paid.
  • Number of days of payables (days payable outstanding = DPO) is equal to the ratio of (accounts payable) and (purchases per day). This ratio tells within how many days the company pays its suppliers.

Cash Conversion Cycle Example

Here is an example showing how the CCC is calculated.

The table presents the information regarding the liquidity of the company:

Value

Inventory

USD 100,000

Cost of goods sold per day

USD 5,000

Accounts payable

USD 108,000

Average day's purchases

USD 4,000

Number of days of receivables

17

The net operating cycle (CCC) is closest to:

  • A. 10.
  • B. 37.
  • C. 64.

Answer A is correct.

Because the CCC is given in days, first we need to compute the DOH and the DPO using the following equations:

\(\text{DOH}=\frac{\text{Inventory}}{\text{Cost of goods sold per day}}=\frac{100000}{5000}=20\text{ days}\)

\(\text{DOH}=\frac{\text{Inventory}}{\text{COGS per day}}=\\=\frac{100000}{5000}=20\text{ days}\)

\(\text{DPO}=\frac{\text{Accounts payable}}{\text{Average day's purchases}}=\frac{108000}{4000}=27\text{ days}\)

\(\text{DPO}=\frac{\text{Accounts payable}}{\text{Average day's purchases}}=\\=\frac{108000}{4000}=27\text{ days}\)

The net operating cycle is:

\(CCC=DOH+DSO-DPO=20+17-27=10\text{ days}\)

\(CCC=DOH+DSO-DPO=\\=20+17-27=10\text{ days}\)


Cash Conversion Cycle Analysis

Generally, the lower the CCC is, the better. A lower cash conversion cycle means that the company needs fewer days to recover money spent on materials.

What does a negative cash conversion cycle mean?

If a company has a negative cash conversion cycle, it means that the company needs less time to sell its inventory (or produce it from raw materials) and receive cash from its customers compared to time in which it has to pay its suppliers of the inventory (or raw materials).


Related Terms: Operating Cycle

Operating cycle measures the time needed to convert raw materials into cash obtained from the sale of finished products:

\(\text{operating cycle}=\text{DOH}+\text{DSO}\)

Note: The net operating cycle (cash conversion cycle, CCC) is equal to operating cycle less the number of days of payables.


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