The cash conversion cycle is an important financial concept many businesses monitor closely. This financial metric helps to assess the time it takes to convert investments into inventory, raw material, and to cash flow.
Understanding how long it takes a business to generate cash flow from its operations is critical to assessing its financial health. The following FAQ will address what the cash conversion cycle is and how to calculate it.
What Is The Cash Conversion Cycle?
In simple terms, the cash conversion cycle is the amount of time it takes a business to convert resources into cash from sales. It is expressed in terms of time, usually days, and takes into consideration investments in all resources used to produce cash from sales.
One of the unique aspects of the cash conversion cycle is that it takes into account the entire cycle of cash production from start to finish. This means that it incorporates the time it takes to collect accounts receivables, settle accounts payable, and even the amount of time it takes to sell inventory.
Because each industry is different and requires different types of investments to produce cash from sales, the metric and even the calculation varies across industries.
How To The Calculate Cash Conversion Cycle
The formula for calculating cash conversion cycle incorporates the sum of aggregate time required across three primary stages of cash conversion. The three stages of the cash conversion cycle are :
- Days of inventory outstanding (DIO)
- Days sales outstanding (DSO)
- Days payables outstanding (DPO)
Therefore, the formula for calculating cash conversion cycle is simply:
DIO + DSO – DPO, or
Days of inventory outstanding + days sales outstanding – days payables outstanding
You might notice that the formula deducts amounts for days payables outstanding. This is because the settlement of accounts payable is considered a cash outflow, and as such is accounted for in the formula as a negative.
Another way to remember this is to consider that DIO and DSO are both related to inventory and accounts receivable, which are considered short term assets, while DPO is related to payables, a short term liability.
Cash Conversion Cycle and the Financial Statements
In order to calculate the cash conversion cycle you will need to refer to the financial statements for the relevant inputs for the three primary stages of cash conversion.
Additionally, you will need to establish a time period for the conversion period. A typical cash conversion cycle is reviewed quarterly but each industry has different cash demands, making it important to select a time frame that is relevant for the industry the business operates within.
The following items will be required to calculate cash conversion:
- Revenue and Cost of Goods Sold (COGS) – Income Statement (or, Statement of Operations)
- Inventory at the beginning of the time period
- Accounts Receivable at both beginning and end of the time period
- Accounts Payable at both beginning and end of the time period
- Number of days in the time period
Step 1: Calculate Days of Inventory Outstanding
The first step in calculating cash conversion is to identify how long it takes the business to sell its inventory. In this case, the lower the number of days the better.
The formula for calculating DIO is:
Where:
Step 2: Calculate Days Sales Outstanding
The second step is concerned with identifying how long it takes the business to collect cash it generates from sales. Again, a smaller number is preferred as it demonstrates the business is effective at collecting on its accounts receivable.
The formula for calculating DSO is:
Where:
And,
Step 3: Calculate Days Payable Outstanding
The final step is focused on understanding how many days it takes the business to pay its suppliers and other service providers that have a hand in the final product being sold. In this case, a higher number is desirable as it shows favorable terms and efficient cash utilization.
The formula for calculating DPO is:
Where:
And,
Step 4: Combine the results to calculate cash conversion
Once these three metrics have been calculated combine the results in the cash conversion formula:
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