Cash Conversion Cycle

The cash conversion cycle is defined as the length of time between the purchase of raw materials and the collection of accounts receivable generated in the sale of the final product. The cash conversion cycle measures the amount of time each net input dollar is tied up in the production and sales process before it is converted into cash through sales to customers. It is also known as cash cycle, asset conversion cycle or a net operating cycle.

The cash conversion cycle is a metric that looks at the amount of time needed to sell inventory, the amount of time needed to collect receivables and the length of time the company is afforded to pay its bills without incurring penalties. It evaluates the current financial stability of the company. Cash conversion cycle is calculated as

CCC = DIO + DSO - DPO

Where
DIO= days inventory outstanding
DSO= days sales outstanding
DPO= days payable outstanding

A company usually acquires inventory on credit and it results in accounts payable. A company which sells products on credit results in accounts receivable. Cash, therefore, is not involved until the company pays the accounts payable and collects accounts receivable. So the cash conversion cycle measures the time between outlay of cash and cash recovery.

The cash conversion cycle may face problem in the area of Accounts Receivable, if some customers are taking longer to pay outstanding invoices for the delivered goods. The company should take corrective steps if a long cash conversion cycle is indicated and it is important to analyze the situation thoroughly and to uncover what is causing the delays.

The cash conversion cycle is an extremely important for retailers and similar businesses. This is because this measure illustrates how quickly a company can convert its products into cash through sales. The result indicates that shorter the cycle, the less time capital is tied up in the business process, and thus the better for the company's bottom line.

Questions:

• What is cash conversion cycle?
• How is it useful in a business?