Cash Conversion Cycle:
Meaning and Significance:
Cash conversion Cycle also known as Operating Cycle is a time taken by the company to generate cash flows from operating activity. The cash conversion cycle is driven by three components. Materials it purchases as raw materials to make finished good and inventories it keeps meeting market demand and supply and to receive the payment for sales it did during the year. This essential measures companies operating robustness in converting its inventories to sales and collect payments to generate cash flow for business in a cyclical manner as it’s a continuous activity.
The CCC various from company to company and from industry to industry, for example the CCC in retail chains like Walmart can be very quick compared to heavy material industries like steel and capital goods manufacturers. To arrive at a logical conclusion on Cash Conversation cycle of a company the industry analysis with its peers needs to be taken up. It makes more sense if the one chose to take companies in similar size and geography along with same business operating models.
Raw material purchase is Accounts Payables to vendors.
Inventory is a stock the companies keep inhouse as finished goods and as Raw materials.
Accounts Receivables are the cash inflow outstanding from its customers.
Cash Conversion Cycle Formula = Days of Inventory Outstanding + Days of Account Receivables Outstanding – Days of Accounts Payables Outstanding.
Analysis of CCC Formula:
Cash Conversion Cycle is a combination of three major operation efficiency formula.
First: Days of Inventory Outstanding or DIO = Measures the time company takes to convert its inventory into sales.
DIO = Average Inventory (Inventory at the beginning of the year + Inventory at the end of the year /2) / COGS a day (Cost of goods sold / 365 days)
Second: Days of Sales Outstanding or Account Receivables, AR or DSO = Measures the time taken to collect payments from credit sales made during the year.
DSO = Average of Account Receivables (Receivables at the beginning of the year + Receivables at the end of the year / 2) / Sales Per Day (Sales during the year / 365)
Third: Days of Payments Outstanding or Accounts Payables, AP or DPO = This is the timeline in which company makes payment to its Vendor against the bills raised.
DPO = Average Accounts Payable (Accounts payable at the beginning of the year + Accounts payable at the end of the year / 2) / COSG per day (Net Sales during the year / 365)