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CASH CONVERSION CYCLE

OVERVIEW

For a business of any size, a comprehensive understanding of the time that it takes to convert its investments in inventory and other resources into cash flow from sales is imperative. An effective measure to do so is through the Cash Conversion Cycle metric. Also known as the Cash Cycle or Net Operating Cycle, the metric accounts for how much time a business needs to sell its inventory, the time it takes to collect receivables, and the time a business has to pay its expenses without incurring penalties. 

The Components

Although the Cash Conversion Cycle metric itself helps evaluate the efficiency of a company's operations, each component part plays an equally important role in the analysis.

Days Sales Outstanding (DSO) - The average number of days it takes for a business to collect payment after a sale has been made. It gives insight into how quickly customers are paying, if collections are efficient, or if credit is being given to customers that are not credit-worthy. 

Days Inventory Outstanding (DIO) - The average number of days it takes for a business to sell-off inventory. A high ratio may indicate that inventory is in excess or has become sluggish, and a low ratio may indicate excessive discounting or inefficient pricing models leading to compromised profitability. A more comprehensive understanding can be reached when measured against the Optimal Inventory Turnover.

Days Payables Outstanding (DPO) - The average number of days a business takes to pay its expenses and invoices. While for some businesses a high DPO indicates there is available cash to increase working capital and short-term investments, for others it indicates the business may be short of cash and is taking too long to pay creditors.

 

The Tool

Through an in-depth key metric analysis, the Cash Conversion Cycle Tool gives insight into the time it takes to convert investments into cash. Because not every industry or business is the same, effective analysis of the Cash Conversion Cycle is based on trends - steady or decreasing values over multiple periods is a good sign, whiles spikes should warrant a more detailed analysis.

Instructions

The input data is found in the business's financial statements. Any range of data can be used as long as the financial reporting dates remain consistent. 

 

Number of Days in Period - Total number of days in the cycle - annually, quarterly, or year-to-date

Total Sales on Credit - Income Statement; exclude any cash transactions

Cost of Goods Sold - Income Statement

Total Accounts Receivable - Current and Previous Balance Sheet(s) 

Total Inventory - Current and Previous Balance Sheet(s) 

Total Accounts Payable - Current and Previous Balance Sheet(s) 

*for accuracy, enter at least two periods of A/R, Inventory, and A/P

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