The goal is to have a shorter turnaround cycle so that there is less time where cash is tied up in accounts receivable and inventory.
As a startup business owner, understanding key economic metrics is important in forecasting goals and determining your company’s financial health. In previous posts, the experts at Crowdz have discussed topics surrounding invoice financing, cash flow vs. profit, and net margin vs. gross margin.
If you’re unfamiliar with these terms, I suggest bookmarking those posts for later. In the meantime, you’ve likely stumbled across this post because you want to learn more about the cash conversion cycle or CCC for short.
It is an effective capital metric that defines how many days it takes a company to convert cash into inventory, and then back into cash.
Keep reading to learn more about the definition, importance, and calculation formula for a cash cycle.
Determining the cash conversion cycle is an especially important measurement for companies that buy and manage inventory. This is because CCC expresses the amount of time, in days, it takes an organization to convert investments in inventory to cash.
The goal is to have a shorter turnaround cycle so that there is less time where cash is tied up in accounts receivable and inventory.
While this is a good sign that a company is in good financial health, it should not be the only metric organizations are measuring. For instance, a company that does not hold physical inventory will not see as much value in measuring its CCC.
To showcase the importance of measuring the cash conversion cycle for an inventory-based business, let’s use the example of a t-shirt company.
Let’s say Company A sells unique t-shirts that people want to buy. As a result cash cycles through the business quickly, allowing the company to fund more inventory, pay employees, and grow their business.
However, if Company A fails to sell its product, its CCC starts to slow down. As a result, too many unsold t-shirts start to build up and cash is tied up in a product that cannot be sold.
In order to sell t-shirts more quickly, the retail company must reduce prices and even consider selling its products at a loss. This outcome is detrimental to the organization.
In short, the shorter the CCC, the better.
The formula for calculating CCC is the following: CCC = DIO + DSO – DPO.
To properly calculate your cash conversion cycle, you’ll first need to identify different metrics from your billing and payment processes.
Days in inventory (DIO).
DIO = Average inventory/Cost of goods sold (COGS) per day
How many days does it take to sell your entire inventory? To determine your average inventory, first, calculate your beginning inventory plus your ending inventory and divide that number by 2.
Days sales outstanding (DSO)
DSO = Average AR / Revenue per day
How many days does it take your company to receive payment from a sale? The smaller the number the better. To determine your average AR, calculate your beginning AR plus your ending AR and divide that number by 2.
Days payable outstanding (DPO)
DPO = Average AP/COGS per day
What is your company’s payment of your own bills or AP? A longer DPO is better. To determine your average AP, calculate your beginning AP plus your ending AP and divide that number by 2.
Positive cash flow makes your day-to-day business operations flow more easily and it also speeds up your timeline on paying creditors. Therefore, many businesses look to shorten their cash conversion cycle to help boost their bottom line.
Here are a few proven tips for small to midsize business owners.
Manage your inventory more efficiently.
Simply put, the faster a business sells its products and services, the sooner it takes in cash from sales. Consider utilizing inventory automation software so your stock is updated in real-time and you instantly know when a sale is made. It eliminates a lot of the tedious tasks that slow down proper inventory management and hold up cash flow.
Take advantage of invoice financing.
How fast your customers pay has a substantial impact on your CCC. Instead of waiting for 30, 60, or even, 90+ days to collect your accounts receivables, earn funds faster with invoice financing. It is a type of asset-based financing where business owners can earn capital advance in exchange for their unpaid invoices.
Learn more about the process and how Crowdz can help.
Pay your accounts payable later.
While it helps business owners to receive payment from their customers early or on time, there is no benefit for businesses to do the same for their suppliers. Your cash on hand increases if you pay your accounts payable as close to the due date as possible. To achieve this, work with your accounting team to create a payables management system where invoices are paid exactly as the terms were negotiated in the contract.
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