How to calculate the cash conversion cycle?
The cash conversion cycle is considered a metric that expresses the length of time, in days, that is takes for a company to convert inputs into cash flows. The cash conversion cycle is computed as follow:
To calculate the cash conversion cycle, you will need to calculate days in inventory (DIO), days sales in accounts receivable (DSO), and days of payables outstanding (DPO). Fortunately, we have a our mental map for the cash conversion cycle that breaks down this process into four simple and repeatable steps:
Below is a description of each step that is part of the cash conversion cycle:
Step 1) Days in inventory (DIO) – The days in inventory ratio indicates how long it takes a company to purchase raw materials, manufacture a product, and then sell the product to an end customer. A company would want this ratio to be as low as possible as it means they can convert their investment in raw materials into the sale of a product quickly. DIO can range widely depending on how long it takes for a company to manufacture, distribute, and sell the product to the end customer.
To calculate days in inventory, you would take ending inventory and divide by daily cost of goods sold. Daily cost of goods sold would be calculated as annual cost of good sold divided by the number of days in the period. Typically, this ratio is calculated on an annual basis, so the number of days in the period would be 365 days.
Step 2) Days sales in accounts receivable (DSO) – Days sales in accounts receivable is a metric that reflects the success that the firm has in collecting receivables that remain outstanding. A higher amount of days will generally indicate that the company is taking a longer amount of time to collect its receivables. A lower ratio indicates that the company can collect their receivables more quickly. The DSO for a company should align closely with the invoice terms they have for their customers. For example, if the company has invoice terms of net 30, then the DSO should be around 30 days.
To calculate days sales in accounts receivable, you would take ending accounts receivable (net) and divide by daily sales. Daily sales would be calculated as annual sales divided by the number of days in the period. Typically, this ratio is calculated on an annual basis, so the number of days in the period would be 365 days.
Step 3) Days of payables outstanding (DPO) – Days payables outstanding is a metric that reflects the average time (in days) that an organization will take to pay off its debt outstanding. Generally, a higher days payables outstanding ratio will indicate that it takes a company a longer amount of time to pay off its bills. The DPO for most companies is typically around 30 days as this aligns with the invoice terms a company would have with their suppliers.
To calculate days of payables outstanding, you would take ending accounts payable and divide by daily cost of goods sold. Daily cost of goods sold would be calculated as annual cost of good sold divided by the number of days in the period. Typically, this ratio is calculated on an annual basis, so the number of days in the period would be 365 days.
Step 4) Cash conversion cycle (CCC) – Once you have calculated the individual ratios for DIO, DSO, and DPO, you can plug them into the cash conversion cycle formula and that will give you the length of time in days it takes for a company to convert their investment into inventory back into cash.
he YouTube video below will walk you through the mental map for the cash conversion cycle:
Example Calculation of the Cash Conversion Cycle
Prospect Technology is trying to determine their cash conversion cycle for Year 5. The company’s accounting department provided the following financial information:
|Period (# of days)||365 days|
|Cost of goods sold||$250,000|
|Ending accounts receivable, net||$50,000|
|Ending accounts payable||$15,000|
Using the financial information above, what is the cash conversion cycle (in days) for Prospect Technology?
58.40 is the correct answer. We’ll have to go through and calculate each ratio first, and then use our formula to calculate the cash conversion cycle in days.
Step 1) We’ll start by calculating the number of days in inventory. We’ll need to divide ending inventory of $30,000 by daily cost of goods sold of $685, which results in a ratio of 43.8 days.
Step 2) For days sales in A/R, we’ll divide ending A/R of $50,000 by daily sales of $1,370, which results in a ratio of 36.50 days.
Step 3) For days of payable outstanding, we’ll divide ending AP of $15,000 by daily cost of goods sold of $685, results in a ratio of 21.9 days.
Step 4) Now that we have the individual activity ratios, we’ll take a DIO of 43.8 days, add a DSO of 36.5 days, and subtract a DPO of 21.9 days. That results in a cash conversion cycle of 58.4 days. This means it takes Prospect 58.4 days to convert its investment in inventory back into cash to use to grow the business.
The YouTube video below will walk you through the example question and provide additional context for each step along the way:
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