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written by | September 9, 2022

A Detailed Guide About What is a Cash Conversion Cycle

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A company’s Cash Conversion Cycle measures the approximate number of days it takes to generate cash return from its cash investment in the business. It is also called the cash cycle, cash flow cycle, cash-to-cash cycle and cash realisation model. A company will mostly prefer to buy any inventory or raw materials on credit, called Accounts Payable. Similarly, most of the time, they will sell that inventory on credit, called Accounts Receivables.

If your vendors are financing your business which means your inventories are sold out before you have to pay for them. If your business has greater liquidity, then it is called the negative Cash Conversion Cycle. So, when a Cash Conversion Cycle is a short or even a negative number, then it is called a good Cash Conversion Cycle.

Did you know? Apple has a “Negative” Cash Conversion Cycle. That’s Amazing! The CCC of Apple for the second quarter ended in June 2022 was -68.92, and this makes the company the one with better management.

Also read: What Is Branch Accounting? Learn About Branch Accounting Types & Examples

What is the Cash Conversion Cycle?

  • Described as a ratio, the Cash Conversion Cycle (CCC) calculates the amount of time (measured in days) it takes for a business to convert its investment in inventory and other resources into cash flow generated from sales by the company.
  • CCC, also known as the Net Operating Cycle, measures how long money is held in the production and sales processes before it is converted into cash.
  • This metric calculates how long it takes for a company to sell inventory, collect receivables, and pay bills. It also calculates the time taken for a company to sell its inventories.
  • An organisation's CCC is one quantitative measure used to evaluate its management and operations efficiency.
  • One should bear in mind that CCC applies only to select sectors dependent on inventory management and related operations.
  • CCC only applies to certain sectors that depend on inventory management and related activities.

Three Parts of the Cash Cycle

The cash cycle has three different parts in it. They are,

DIO – Days Inventory Outstanding

DSO – Days Sales Outstanding

DPO – Days Payable Outstanding

  • DIO represents the current inventory level and the time taken for the company to sell this inventory.
  • DSO represents the current sales and the time taken for the company to collect cash for these sales.
  • DPO represents the amount of money the company has to pay its vendors and when the company is going to pay their vendors.

Also read: Understand Cash Accounting - Cash Account Meaning, Advantages And Limitations

How to Calculate Cash Conversion Cycle? 

The Cash Conversion Cycle can be calculated by the below formula.

CCC = DIO + DSO - DPO

Where the DIO, DSO and DPO can be calculated by,

                        DIO = (Average of inventory/Cost of goods sold) *365

                        DSO = (Average of accounts receivables/Total credit sales) *365

                        DPO = (Average of accounts payable/Cost of goods sold) *365

Example: A company reported ₹1000 as beginning inventory and ₹3000 as ending inventory for the year ended 2018, with the cost of goods sold as ₹40,000. And it has ₹4000 as beginning Accounts Receivables and ₹6000 as ending Accounts Receivables, along with a credit sale of ₹1,20,000. Also, it has ₹1000 as beginning Accounts Payable and ₹2000 as ending Accounts Payable. Calculate CCC to assess the company’s cash conversion performance.

We can first calculate DIO, DSO and DPO using the formulas here.

To calculate DIO: Average inventory = (₹1000 ₹3000)/2 = ₹2000

DIO = (₹2000/₹40000) *365 = 18.25

To Calculate DSO: Average accounts receivable = (₹4000₹6000)/2 = ₹5000

DSO = (₹5000/₹1,20,000) *365 = 15.2

To Calculate DPO: Average accounts payable = (₹1000₹2000)/2 = ₹1500

DPO = (₹1500/₹40,000) *365 = 13.69

Now, putting all the three together, CCC can be calculated as

                                    CCC = DIO+ DSO - DPO

                                    CCC = 18.25 + 15.2 - 13.69 = 19.76 days

Therefore, this company approximately takes 20 days to turn its investments in inventory into cash.

The Interpretation of the Cash Conversion Cycle

The main objective of calculating CCC is to assess how efficiently a company manages its working capital. The shorter the Cash Conversion Cycle, the better the company manages to sell inventories, recover cash from sales and pay suppliers.

Comparing the Cash Conversion Cycle of a company to that of its competitors or its previous cycles can help determine if the firm’s working capital management is improving or declining.

Also, comparing a company's CCC to that of its competitors can help to determine if the company's Cash Conversion Cycle is "normal".

Who Can Use CCC?

Companies like business owners, investors, bankers, accountants and suppliers might use CCC to measure their cash flow. Cash flow decides the profitability of the company.

The CCC works better for the company having inventory as physical goods, whether it is manufactured items or retailed products.

Also read: What Is Accounting Rate of Return (ARR)? Explained With ARR Formula & Example

When Can a Company Use CCC?

Companies prepare documents such as balance sheets, profit and loss statements and cash flow statements to provide necessary information about the inventory and sales. Many companies prepare these either quarterly or annually. This helps to track CCC over some time to observe the trends. It helps to see how a company is improving or growing over some time.

Ideas to Improve Cash Conversion Cycle

Having a good CCC from the debtor’s side means fewer bad debts. Therefore, there would be no need to rely on external agencies or to record a large amount of uncollectible in the company's books.

Using incentives, the firm can optimise its Cash Conversion Cycle. It may be possible for a firm to offer discounts if it wishes to reduce the collection period from the debtors.

The company faces several risks from old inventory remaining in storage houses, including high retention costs, spoilage risks and quality reductions. By improving the inventory conversion rate, the organisation can improve product quality and the bottom line.

On the payables side, a short conversion rate allows the firm to take advantage of the incentives provided by suppliers for instant payments. As a result, the relationship is improved, and the company can enjoy a shorter production cycle than its competitors.

Cash Conversion Cycle Ratio

Companies can turn investments into cash in a shorter amount of time using this ratio. CCC uses the average time to pay suppliers, create inventory, sell products, and collect customer payments. This timeframe should be as short as possible for the company, in general.

Negative Cash Conversion Cycle – ‘Apple’ and ‘Reliance Industries Ltd’ as Examples

An inventory that is sold before it needs to be paid for is said to have a negative Cash Conversion Cycle. To put it another way, your vendors are funding your business. Many businesses benefit from a negative Cash Conversion Cycle. One of the examples of this is Apple.

  • Apple's latest twelve-month cash conversion cycle is -46 days.
  • Apple's financial statements showed that the average cash conversion cycle for fiscal years ending September 2017 to 2021 was -66 days.
  • During the fiscal years ending September 2017 to September 2021, Apple turned over cash at a median rate of -70 days.
  • According to a five-year review, Apple's cash conversion cycle reached -46 days in June 2022.
  • With a cash conversion cycle of -74 days, Apple's cash conversion cycle reached a five-year low in September 2019.
  • In 2017, Apple's cash conversion cycle decreased by 36%; in 2018, it decreased by 5.6%; in 2019, it decreased by 0.3%; and in 2020, it increased by 17.9% and 12% in 2021.
  • The Company's Days Payable for the three months ended in June of 2022 was 97.92. As a result, Apple's Cash Conversion Cycle (CCC) for the three months ending in June 2022 was -63.92, which is a negative number.

Another example is Reliance Industries’ negative cash conversion cycle.

  • Reliance Industries' latest twelve-month cash conversion cycle is -12 days. 
  • From March 2018 to March 2022, Reliance Industries had an average cash conversion cycle of -22 days.
  • Between the fiscal years ending March 2018 and 2022, Reliance Industries' average cash conversion cycle was -19 days.
  • In June 2022, the cash conversion cycle for Reliance Industries peaked at -12 days.
  • March 2018 marked the lowest cash conversion cycle for Reliance Industries in five years.
  • In 2018, the cash conversion cycle of Reliance Industries decreased by 36 days compared to 2016, 2021 and 2022, while increasing in 2019 by 25 days and 2020 by 13 days.
  • The Days Payable for Reliance Industries' three months ended in Jun. 2022 were 95.64. Hence, Reliance Industries' Cash Conversion Cycle (CCC) ended in June 2022 at -20.87, which is a negative number.

So, a negative number on a CCC represents that the company’s performance is good, and it has a greater degree of liquidity with very less working capital tied up for long periods.

Also read: Learn about Inventory Accounting - Meaning, Objectives, Types & Method

Conclusion

Analysis of Cash Conversion Cycles is important because it informs us of the lock-in period for production-related investments. Analysing a company's cash conversion can tell us a lot about how the company operates and what its prospects are. Cash flow cycles can be long if dues are not collected on time or if overproduction is taking place. Several problems can arise when a firm's cash flow cycle is long because it is only possible to pay the bills through cash, not profits. 

The most extreme of these problems is bankruptcy. If the number of days of the cash flow cycle is lower or even negative, the more efficiently the company can utilise its cash resources. It is beneficial for a business to see a lower operating cycle value because it promotes healthy working capital, cash flow, liquidity and profitability. In some cases, calculations will help you determine whether your business will succeed or not. 

Follow Khatabook for the latest updates, news blogs, and articles related to micro, small and medium businesses (MSMEs), business tips, income tax, GST, salary, and accounting.

FAQs

Q: What is an entity’s liquidity ratio?

Ans:

An entity's liquidity ratio measures its ability to meet its current debt obligations without securing additional capital from outside sources.

Q: What is a cash discount?

Ans:

The seller can offer a cash discount as an incentive to a buyer for paying a bill on time or early.

Q: How does one determine a good CCC value?

Ans:

Ideally, a CCC should be as short as possible to run an efficient and profitable business. When the ratio approaches 1, you have great liquidity and your working capital isn't stuck for long.

Q: What is a good Cash Conversion Cycle?

Ans:

A period of 13 weeks is usually recommended since most businesses will have sufficient cash flow data to calculate accurately during that period.

Q: What is working capital management?

Ans:

Management of working capital involves monitoring a company's assets and liabilities to ensure its smooth functioning.

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The information, product and services provided on this website are provided on an “as is” and “as available” basis without any warranty or representation, express or implied. Khatabook Blogs are meant purely for educational discussion of financial products and services. Khatabook does not make a guarantee that the service will meet your requirements, or that it will be uninterrupted, timely and secure, and that errors, if any, will be corrected. The material and information contained herein is for general information purposes only. Consult a professional before relying on the information to make any legal, financial or business decisions. Use this information strictly at your own risk. Khatabook will not be liable for any false, inaccurate or incomplete information present on the website. Although every effort is made to ensure that the information contained in this website is updated, relevant and accurate, Khatabook makes no guarantees about the completeness, reliability, accuracy, suitability or availability with respect to the website or the information, product, services or related graphics contained on the website for any purpose. Khatabook will not be liable for the website being temporarily unavailable, due to any technical issues or otherwise, beyond its control and for any loss or damage suffered as a result of the use of or access to, or inability to use or access to this website whatsoever.
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Disclaimer :
The information, product and services provided on this website are provided on an “as is” and “as available” basis without any warranty or representation, express or implied. Khatabook Blogs are meant purely for educational discussion of financial products and services. Khatabook does not make a guarantee that the service will meet your requirements, or that it will be uninterrupted, timely and secure, and that errors, if any, will be corrected. The material and information contained herein is for general information purposes only. Consult a professional before relying on the information to make any legal, financial or business decisions. Use this information strictly at your own risk. Khatabook will not be liable for any false, inaccurate or incomplete information present on the website. Although every effort is made to ensure that the information contained in this website is updated, relevant and accurate, Khatabook makes no guarantees about the completeness, reliability, accuracy, suitability or availability with respect to the website or the information, product, services or related graphics contained on the website for any purpose. Khatabook will not be liable for the website being temporarily unavailable, due to any technical issues or otherwise, beyond its control and for any loss or damage suffered as a result of the use of or access to, or inability to use or access to this website whatsoever.