The Cash Conversion Cycle

If you read my postings on a regular basis I may sound like a broken record with how much I focus on cash. But again, as I’ve said before, “Profit is nothing until it is converted to cash.” See Cash Flow – The Bottom Line. Now I want to delve into how efficiently we convert financial activity to cash.

Cash Conversion Cycle Formula

First we need to identify some abbreviations and definitions:

DSO for days sales outstanding

DIO for days inventory outstanding

DPO for days payable outstanding

DSO = Average accounts receivable for the year / average daily sales for the year

DIO = Average inventory for the year / average daily cost of goods sold

DPO = Average accounts payable for the year / average daily cost of goods sold

Using the above the formula to calculate the cash conversion cycle is:

Cash Conversion Cycle = DSO + DIO – DPO

An Example

Assume the following for a company:

Beginning Accounts Receivable = $1,000,000

Ending Accounts Receivable = $1,100,000

Average Accounts Receivable = ($1,000,000 + $1,100,000) / 2 = $1,050,000

Beginning Inventory = $2,000,000

Ending Inventory = $2,500,000

Average Inventory = ($2,000,000 + $2,500,000) / 2 = $2,250,000

Beginning Accounts Payable = $750,000

Ending Accounts Payable = $600,000

Average Accounts Payable = $675,000

 

Annual Sales = $9,125,000

Average Daily Sales = $9,125,000 / 365 = $25,000

Annual Cost of Goods Sold = $5,475,000

Average Daily Cost of Goods Sold = $5,475,000 / 365 = $15,000

Using this information we can make the following calculations:

DSO = $1,050,000 Ave. AR / $25,000 Ave. Sales per day = 42 days

DIO = $2,250,000 Ave. inventory / $15,000 Ave. COGS per day = 150 days

DPO = $675,000 Ave. AP / $15,000 Ave. COGS per day = 45 days

Now we can use the formula to calculate the cash conversion cycle.

Cash Conversion Cycle = DSO + DIO – DPO

Cash Conversion Cycle = 42 +150 – 45 = 147 days

What Does It All Mean

The cash conversion cycle represents the time it takes for a company to sell its inventory, collect the resulting accounts receivable and pay the accounts payable. The smaller the number the more liquid the company is. As you can see from the example above, there is an average of five months of inventory on hand (calculated as 150 days / 30 = 4.7). This is a classic case where better inventory management could reduce the time to convert activities to cash. If the average inventory was cut in half then the DIO would be 75 and the cash conversion cycle would be reduced to 72.

I’ll venture to say that not many companies are aware of the significance of this calculation. They should be, as it tells quite a bit about how efficiently a company is managing financial resources.

If you want to know more, contact AimCFO – Contact

As always, your comments are welcomed.

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