A clear view of your business with the cash conversion cycle
For birthdays, surprises can be great. When you're a small business fighting for life? Surprises are generally an unwelcome euphemism for "bad news." Great decision making is everything when it comes to avoiding ugly surprises, and few things help inform decision making like understanding your cash conversion cycle (CCC).
To help you make more informed decisions around your inventory and business management, we'll take a look at what the CCC is. Then, we'll tackle its usefulness and how you can go about calculating your CCC.
What is the cash conversion cycle?
It's easy to think of the sales cycle as multiple independent pieces. But the sales cycle is one continuous flow of inventory, promotion, and sales. Any time you're deciding to invest in more inventory, you're already taking the first step in the sales cycle. From there your inventory has to be displayed and then sold, then accounts receivable has to receive the actual money for the purchase.
All of these steps impact your cash flow: A lengthy sales cycle can cause financial hangups, bad pricing can hurt your revenue per-item sold, long payment times can tie up needed funds, and so on.
The cash conversion cycle helps you determine how long it takes for the money you spend on inventory to convert into actual cash flow. Simply put, the CCC gives you an estimate on how long your money takes to go from investment to pay out.
Why is the CCC useful?
Your company's cash conversion cycle provides a lot of insight into your business operations and potential operational problems. Some of the issues the CCC can help you find include:
- Company health over time: The first time you determine your CCC you'll find some usefulness, but the CCC's usefulness will actually grow over time. As you complete each CCC you'll be able to see how your company is doing now, versus a year or two ago.
- Inventory cost issues: Raw materials can be costly. As you figure out your CCC, you might notice the cost of raw materials for your average inventory is impacting your bottom line more than you initially expected.
- Poor product pricing: Your products may appear profitable enough at first. But if you run your CCC and realize it's taking you longer than you planned to turn investments into profit, you may want to rethink your pricing and do another round of pricing optimization.
- Invoice latency: It's entirely possible your CCC is higher than expected simply because of invoicing issues. If the average number of days for an invoice to be paid is a month, for example, you might want to institute a plan to shorten invoice time.
Again, your CCC will only become more useful over time. The sooner you figure out your CCC, the sooner you'll be able to compare it to future CCC iterations. Now, let's figure out how you can actually determine your CCC.
How to determine your cash conversion cycle
A cash conversion cycle is a rather complex number to crunch. There are a few elements that go into the formula, each of which needs to be calculated before you get to the CCC formula.
Days of inventory outstanding
The first piece of the CCC puzzle is the days of inventory outstanding (DIO). This is the amount of time it takes for your inventory to complete its entire lifecycle, from production to sale. Simply put, DIO is your inventory turnover time from beginning to end.
To determine your DIO, use the following formula:
"DIO = (average inventory ÷ cost of goods sold) × 365"
Your average inventory can be found by taking your beginning inventory and ending inventory for an accounting period, and dividing them by two.
The cost of goods sold (COGS), often known as variable cost of goods sold, can be found with this formula:
"Variable cost per unit = total variable costs ÷ number of units"
Once you have these pieces of information you can solve for days inventory outstanding. Your DIO on its own is also useful, in that it will help you understand if your production process is taking too long. It can also shine light on sales process issues, as it’s possible your production is speedy but sales are lagging.
Days sales outstanding
The next part of the cash conversion cycle formula is days sales outstanding (DSO). Where DIO measured the time inventory takes to go from production to sale, DSO tells you how long it takes for invoices to be paid. Think of this as the average accounts receivable turnaround time.
To solve for DSO, use this formula:
"DSO = (accounts receivable paid ÷ total credit sales) × days in pay period"
For this formula, you can use any period of time you'd like, from a month of billing to a full fiscal year. But, whatever period you use needs to be applied to accounts receivable and sales, as well as the days in that period.
For example, if you use a month as your period, you would have your sales for the month on the bottom, with the accounts receivables amounts paid for that month on top, multiplied by the number of days in the month. Using this same monthly period, let’s say you had $40,000 in accounts receivable paid, but $55,000 in total sales. The formula would look like:
"DSO = ($40,000 ÷ $55,000) × 30"
A quick turnover ratio is generally anything around a month, but this can vary depending on your industry and sales cycle. Ideally, you want a quick ratio as opposed to a longer length of time. Keep track of your turnover ratio as you continue to determine your days sales outstanding to ensure there isn't an emerging problem. If you notice your turnover ratio is getting higher and higher, there’s clearly an issue with your invoicing process or accounts receivable.
Days payable outstanding
The last piece of the CCC puzzle is the days payable outstanding (DPO). This formula tells you how long it takes for you to pay any credit or invoices you owe. This includes agencies, third-parties, vendors, and even suppliers you're paying for the raw materials used in manufacturing your products. The higher your DPO, the longer you take to pay your debts.
To find your DPO, you'll need this formula:
"DPO = average accounts payable × days in period ÷ cost of goods sold"
A higher days payable outstanding isn't necessarily a bad thing, as it could mean you have more working capital between paying your debts. But, if your DPO is climbing and climbing, it could point to a debt you simply can't handle.
The CCC formula
With your DIO, DSO, and DPO, you can now determine your CCC. That's a whole lot of letters, but they yield a ton of useful info.
Before solving for CCC, be sure to double- and triple-check each of the pieces you've already solved for. If any of the numbers are off, your entire CCC will be off. Once you're sure the pieces are accurate, use this formula to find your CCC:
"CCC = DIO + DSO − DPO"
Once you find your CCC, take note and set a reminder to crunch the numbers and update it in the future. There are no hard and fast rules around how often you should find your CCC, but the more the merrier. Staying on top of this number ensures you're not blindsided by a sudden realization that your CCC is double or triple what it was a year ago.
If you notice a negative cash conversion cycle, that's actually a great thing. It means you're receiving money owed quickly and turning inventory into sales in a speedy manner. A higher CCC means you're not receiving working capital in a quick enough manner and your funds are getting tied up somewhere in the process.
Know CCC, no surprises
Calculating your CCC takes a lot of time, but it's time well spent. The sooner you know your CCC, the sooner you can determine if there's a problem or bottleneck somewhere in your production or sales process.
Every company needs working capital to stay afloat and be prepared in the event of an emergency. When you know your CCC, there are no surprises.