How’s your cash conversion?
| This is an installment in our monthly metrics segment. Previously: Days Sales Outstanding Growth Rate |
Today, we’ll cover the Cash Conversion Cycle (CCC). It’s a bit of an advanced concept, but worth the investment.
For starters, here’s a stripped down definition of operating cash flow:
Operating Cash Flow = Profit + Depreciation +/- Working Capital
You’ll notice working capital can add or detract from operating cash flow. The CCC is a way to measure just that working capital portion of cash flow (since it’s arguably one of the peskiest financial concepts on earth).
1) What is it (CCC)?
CCC measures how long (in days) it takes a dollar of cash to move through your business, from start to finish.
Think of it this way, you’re a retailer and you just placed an order for 1,000 units of your best-selling product; how long until those 1,000 units are sold, shipped, and the cash is collected? That’s your CCC.
It combines the 3 working capital metrics:
- Days Sales Outstanding — length of time to collect sales
- Days Inventory on Hand — length of time to store and sell inventory
- Days Payable Outstanding — length of time to pay bills
2) How to calculate it?
Starting with some basic formulas you’ll need to know…
- Working capital = A/R + Inventory – A/P
- Cash Conversion Cycle = DSO + DIH – DPO
- DSO, DIH, DPO outlined below:
What we’re measuring is: 1) the average length of time we hold onto inventory before we sell it; plus 2) the average length of time it takes us to collect from our customers; minus 3) the average length of time we take to pay our supplier bills.
Remember, working capital is expressed in dollars, it’s the dollar amount you have tied up in those accounts on your balance sheet. CCC is expressed in days, it’s how long it takes those dollars to come back to you in the form of a collected sale.
3) Why is this so important?
Your CCC is one number to rule them all when it comes to measuring cash flows from working capital. Pretty sweet.
Plus, it’s measured in days which is intuitive for owners and employees. Those days are easily translated to dollars to measure the actual cash impact too.
It varies based on how much working capital is needed in your business. See the chart below for various cash cycles of different business models. Retailers typically carry lots of inventory and have a higher CCC than a restaurant for example, which has no inventory and customers pay via credit card.
Usually, your CCC is the limiting factor when it comes to: 1) turning profits into cash flow; and 2) growing your business. Both of which are on most business owners’ bingo card.
4) How to use it?
Try plugging your financial data into this simple calculator to determine your CCC trends over time:
From there, look at the trends to determine whether you have a working capital problem and which bucket is leaking (A/R, inventory, or A/P). Then, you can begin taking steps for corrective action.
Want to free up more cash?
Bring this number down. There are even rare business models with a negative cash cycle, meaning they get paid before they shell out cash to suppliers or inventory.
Here’s my approach…
I want to find benchmark cash cycles for my industry and try to operate at a level better than average. If my peers are running 90 days to convert cash and I’m at 110 days, then something in my business model is off. Perhaps I’m getting no terms from my suppliers or I’m overstocked on inventory.
Then, I want to keep tabs on my CCC over time (i.e. trends) and make sure they stay within guardrails. For example, my peers are at 90 days and I want to be at 80 days. I’ll want give myself some wiggle room and stay within 80-90 days.
Example:
Check out the company below. It’s a visual of 10 years’ worth of cash conversion days. What do you think of recent performance (i.e. since 2022)? Though trends have improved since then, do you think this company has opportunity for more improvement?
