What is the Cash Conversion Cycle?
The Cash Conversion Cycle (CCC) measures the approximate number of days it takes a company to convert its inventory into cash after a sale to a customer.
- Conceptually, what is the meaning of the cash conversion cycle?
- Which factors impact the cash conversion cycle?
- What does an uptrend or downtrend in CCC imply about the operating efficiency of a company?
- If a company has a negative CCC, would be this a positive sign or a cause for concern?
Table of Contents
How to Calculate the Cash Conversion Cycle
The cash conversion cycle (CCC) measures the amount of time required for the company to clear out its stored inventory, turn its outstanding accounts receivables (A/R) balance into cash, and how long the payment date to suppliers for goods/services received can be pushed out.
The “cycle” refers to the process companies undergo in purchasing inventory, selling the inventory to customers on credit (i.e., accounts receivable), and collecting cash payments from these customers.
The calculation of CCC is composed of three working capital metrics:
For a quick review of the working capital metrics mentioned, see the chart summarizing the main points below.
The reason why CCC is such an important metric to track is that it can be used to evaluate the operating efficiency of a particular company, as well as the decision-making capabilities of the management team.
One of the main reasons that the net income falls short in capturing the actual liquidity of the company is due to working capital – most notably, inventory, accounts receivable (A/R) and accounts payable (A/P).
- Inventory: In the best-case scenario, the amount of inventory purchased and type of products sold should be met with adequate demand from the market (i.e., there is no build-up of inventory that the company is encountering difficulty in selling)
- Accounts Receivable: For A/R, customers that previously paid using credit rather than cash are paying off their outstanding balance sooner. Despite the revenue being recognized (i.e., “earned”) on the income statement under accrual accounting standards, the cash has yet to change hands since the customers are delaying their payments
- Accounts Payable: A/P increasing on the balance sheet suggests the company has “buyer power” (i.e., bargaining leverage when it comes to negotiating supplier terms), which enables them to delay payments – as the seller awaits the payment from the buyer, the buyer is then free to use that cash for a variety of other purposes
Interpreting the Cash Conversion Cycle (CCC)
As a generalization, companies with lower CCCs tend to be better off from a cash management perspective.
If CCC is trending downward relative to previous periods, that would be a positive sign, whereas CCC trending upward points towards potential inefficiencies in the business model.
- A higher cash conversion cycle means the real cash flow profile of the company deviates further from how it is portrayed on the income statement.
- Low CCCs are often a byproduct of clearing out inventory quickly, possessing bargaining power over suppliers, and having payment collection processes in place that are effective at retrieving cash from customers that paid on credit.
CCCs that are high relative to the industry benchmark indicate that a larger proportion of the company’s cash is tied up in its operations – for instance, the company might be holding onto inventory in its storage facilities for an extensive duration of time before those items are sold.
Cash Conversion Cycle Formula
Cash Conversion Cycle (CCC) Formula
- Cash Conversion Cycle = DIO + DSO – DPO
The first portion of the formula, “DIO + DSO” is called the operating cycle, which is the number of days on average for inventory to be converted into finished goods and then sold, plus the average number of days receivables (A/R) remain outstanding on the balance sheet before cash collection.
To finish calculating the CCC, the average duration that the company takes to pay off its outstanding accounts payable (A/P) balance is deducted from the operating cycle.
Hence, the CCC is used interchangeably with the term “net” operating cycle. Given that a lower CCC is preferred, it should be intuitive as to why DIO and DSO are added (increase in CCC = negative FCF impact) while DPO is subtracted (decrease in CCC = positive FCF impact).
Putting together the above, the CCC is equal to the average time needed for inventory to be sold and cash collected from customers – minus the timing “gap” in between receiving products or services from suppliers/vendors and the date of actual payment.
Note how in the table below, the NWC changes on the left side each have positive implications on free cash flow (FCF). In comparison, the right side shows the opposing change and contrasting impact on FCFs.
|Positive Levers (Higher FCF)||Negative Levers (Lower FCF)|
The target number of days for the CCC differs substantially by the industry the company operates within and the nature of products/services sold (e.g., purchase frequency, order volume, seasonality, cyclicality).
However, for the most part, the lower the CCC, the more beneficial it is for the company, as it implies that less time is needed to convert working capital into cash on hand. In addition, it is particularly useful to track the CCC metric for a particular company year-over-year (YoY) – and to benchmark against comparables peers in the same industry.
Negative Cash Conversion Cycle – Amazon Example
A positive cash conversion cycle, even if on the lower end relative to comparable companies, is still a “use” of cash at the end of the day.
While an uncommon occurrence, certain companies can have negative CCCs, which means the net impact is a “source” of cash.
A negative CCC would be accomplished by turning over inventory frequently and receiving cash payments for products sold before needing to pay suppliers.
One of the most frequently cited examples of companies that have a negative CCC is Amazon. By having a negative CCC, Amazon was able to essentially finance its operations through its favorable delayed payment terms with suppliers due to the time lag; but unlike traditional debt financing, this came with no interest.
For an unprofitable company with steep losses, this freely available cash helped fund Amazon’s growth initiatives and played an influential role in shaping the company into what it is today.
Even compared to other market leaders such as Walmart which are known for their efficiency, Amazon had a significantly lower CCC that dipped below zero.
Amazon Cash Conversion Cycle (Source: HBR)
Cash Conversion Cycle Calculator – Excel Template
We’ll now move to a modeling exercise, which you can access by filling out the form below.
Cash Conversion Cycle (CCC) Calculation
Here, in our simple example, the company has the following working capital metrics:
- DIO of 85 in 2017 – decreasing by 1 day each year
- DSO of 40 in 2017 – decreasing by 2 days each year
- DPO of 60 in 2017 – increasing by 2 days each year
Given those assumptions, we can tell the company has been gradually improving in all three categories. Upon extending the 2017 hardcoded assumptions and step function into the rest of the years, we can calculate the historical CCC for 2018 to 2020 using the formula shown below.
The completed output sheet is posted below along with a chart illustrating the downward trend in the CCC from 65 days in 2017 to 50 days by 2020.
This type of year-over-year progress demonstrates that management has been able to identify areas in the business model that require improvement and effectively implement the required adjustments to produce tangible results.