If you own a small business, it’s vital to keep tabs on your inventory levels, receivables and payables. Tracking these figures allows you to identify when adjustments may be needed to avoid encountering cash flow issues. The cash conversion cycle is one way to monitor these business trends. Here’s how it works.
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What Is The Cash Conversion Cycle?
The cash conversion cycle (CCC) is a metric that reflects the amount of time it takes for a company to convert inventory or materials the company purchases to cash.
It’s calculated using this formula:
- CCC = Days Inventory Outstanding (DIO) + Days Sales Outstanding (DSO) + Days Payable Outstanding (DPO)
Working Capital Metrics
Days Inventory Outstanding (DIO)
This metric measures the average number of days a company has inventory on hand before it’s sold to a customer. Here’s the calculation:
- DIO = (Average Inventory / Cost of Goods Sold) * 365
For example, assume your company had $900 worth of inventory at the beginning of the year and $2,100 at the end of the year with a cost of goods sold of $28,000. The DIO calculation would be as follows:
- Average Inventory = $1,500 or ($900 + $2,100) / 2
- Cost of Goods Sold = $28,000
- DIO = 19.55 or ($1,500 / $28000) * 365
So, it takes your company around 19 days to move inventory.
Days Sales Outstanding (DSO)
This metric measures the amount of time to collect receivables. The formula is as follows:
- DSO = (Average Accounts Receivable / Total Credit Sales) * 365
To illustrate, if your company started the year with $1,500 in receivables, ended it with $8,000 and had total credit sales of $80,000, here’s how you’d calculate the DSO:
- Average Accounts Receivable: $4,750 or ($1,500 + $8,000) /2
- Total Credit Sales: $80,000
- DSO: 21.67 or ($4,750 / $80,000) * 365
Based on the calculation, it takes your customers 21 days on average to pay their invoices.
Days Payable Outstanding (DPO)
This metric measures the number of days on average it takes your company to pay outstanding invoices, also known as payables. Here’s the formula:
- DPO = (Average Accounts Payable / Cost of Goods Sold) * 365
For example, if your company had $1,000 in payables to start the year, ended with $1,500 and the cost of goods sold was $36,000, here’s how you’d determine the DSO:
- Average Accounts Payable: $1,250 or ($1,000 + $1,500) / 2
- Cost of Goods Sold: $28,000
- DPO: 15.85 or ($3,000 / $28,000) * 365
As evidenced in the calculation above, it takes your company 15 days to pay its invoices.
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Cash Conversion Cycle Formula
Earlier in this guide, you learned that the cash conversion cycle formula is as follows:
- CCC = Days Inventory Outstanding (DIO) + Days Sales Outstanding (DSO) + Days Payable Outstanding (DPO)
Based on the examples above, your company’s CCC would be 25.37 (19.55 for DIO + 21.67 for DSO – 15.85 for DPO). This figure reflects the average number of days it takes for a company to convert inventory or materials your company purchases to cash.
Two Types Of Conversion Cycles
Positive Cash Conversion Cycle
A low CCC typically indicates that your company can move inventory or materials quickly. Simply put, it takes a short period to recoup the funds spent on inventory and materials.
Negative Cash Conversion Cycle
A negative CCC means that your company needs more time to take care of payables (or remit payments to suppliers for inventory and materials) than it does to make sales.
FAQs About Cash Conversion Cycles
Ideally, you want a low cash conversion cycle to avoid cash flow issues. It reflects sound financial management and demonstrates that your company accurately predicts inventory needs, collects receivables by the due date, and has ample time to remit payments to vendors.
It’s best to have a low or negative CCC. Otherwise, your company spends a substantial amount of time working to convert inventory to sales and encounters cash flow issues.
The longer you have inventory in your possession, the more likely you will have minimal working capital on hand. But suppose your CCC is low, and you turn inventory into sales in a short period. In that case, your business is less likely to struggle with keeping the ample amount of working capital on hand needed to keep operations running smoothly.
How to Get an Influx of Cash to Grow Your Business
Whether you have a high or low CCC, there could come a time when you need the influx of cash to grow your business. In that case, a business loan could be worth considering. But with so many options available, maybe you aren’t sure where to start your search for funding.
But don’t fret. Instead, consider Lendio to help you find the perfect loan for your business. It’s a Better Business Bureau (BBB) accredited online platform that features more than 10 funding options from over 75 lenders. You only need to complete one application to explore potential matches, and your credit score won’t be impacted. Here’s how it works:
- Step 1: Complete the online application in 15 minutes or less without a hard pull on your credit.
- Step 2: Compare potential loan offers, and get insight from the Lendio team on which option is best.
- Step 3: Get approved and secure the capital you need. Some lenders offer funding in just 24 hours.
Explore your options with a partner in the Lendio network today. Submit a free, no-obligation application and secure the working capital needed to soar your business to new heights.
