The Ultimate Guide to the Cash Conversion Cycle

The Cash Conversion Cycle formula

To better assess your working capital efficiency, we use the following CCC formula:

Cash Conversion Cycle (CCC) = DIO + DSO – DPO

Where:

• DIO stands for Days Inventory Outstanding
• DSO stands for Days Sales Outstanding
• DPO stands for Days Payable Outstanding

From the graphic above, it becomes clear that the Cash Conversion Cycle or cash operating cycle traces the lifecycle of cash in a business and has 3 distinct phases:

1. DIO = Is the average time it takes a Corporate to sell its inventory on credit
2. DSO = Is the average time it takes a Corporate to collect its cash from its customers or to convert its Receivables to cash
3. DPO = is the average time it takes a Corporate to pay its Suppliers and therefore reduce its Accounts Payable

What is the CCC? The definition of the CCC is a cycle measuring the time it takes for a Corporate to purchase inventory/stock from its Suppliers, sell this inventory/stock on credit, collect its receivables in the form of cash and finally settle its accounts payable.  The lower the CCC indicates the ability of a Corporate to quickly convert its investment in inventory to cash after settling its suppliers.

Food retailers and online retailers often have negative CCC as sales are predominantly for cash and they can negotiate extended payment terms.

Days Inventory Outstanding (DIO)

DIO = AVERAGE INVENTORY/ (COGS/365)

Average number of days that inventory/stock is held or the average number of days it takes a company to convert its inventory/stock into Sales.  A low figure would indicate a level of efficiency in terms of an ability to sell inventory rapidly and effective inventory management.

Matters to consider:

• Inventory write off policy
• Levels of raw materials, WIP and finished goods
• Number of inventory lines
• Automatic re-order levels

Example:

Average Inventory is the average inventory/stock held at the beginning and end of the accounting period.

So, if Corporate XYZ Ltd holds $1m at the beginning of 2022 and $3m at the end of 2022 then the average inventory is ($1m + $3m)/2 = $2m

Cost of Goods Sold (COGS) is the cost of goods sold over the financial year.  If XYZ Ltd has COGS of $100m then the DIO of XYZ Ltd is $2m/($100m/365) = a little over 7 days.

Check out the Treasury & Risk 5 minute webinar: Does Real-Time Really Matter?

Days Sales Outstanding (DSO)

DSO = AVERAGE AR/(TURNOVER/365)

The average number of days sales that Accounts Receivable (AR) represent.

The lower this figure indicates an ability for a Corporate to quickly convert debtors to cash.  A cash business, such as a food retailer, would expect a DSO close to nil.

The DSO is the average number of days it takes a Corporate to collect its receivables or, put another way, the average number of days for a company to collect payment after a sale.

Example:

Using the formula above, if Corporate XYZ Ltd has Accounts Receivable at the beginning of the 2022 financial year amounting to $2m and at the end of the 2022 financial year this figure has increased to $4m then average receivables are ($2m + $4m)/2 = $3m.

XYZ Ltd Turnover for 2022 is $175m so the DSO of XYZ Ltd is $3m/($175m/365) = slightly over 6 days.

Given that the timing of receipts is in the hands of customers, managing Accounts Receivable is often considered the hardest element of working capital to manage.  Processes to consider:

• Customer payments by direct debits if possible
• Use of electronic payment portals and/or electronic payment methods
• Strong STR processes
• Strong Customer Credit management
• Proactive processes for disputed AR accounts
• Early payment discounts but this will have an impact on gross margin

Days Payable Outstanding (DPO)

DPO = AVERAGE AP/(COGS/365)

The average number of days that Accounts Payable are outstanding or, put another way, the average number of days it takes a Corporate to pay back its payables/creditors. The higher the number reflects an ability to hold cash longer and negotiate longer payment terms.

Example:

Average Accounts Payable is the average Accounts Payable held at the beginning and end of the accounting period.

So, if Corporate XYZ Ltd owes $4m to creditors at the beginning of 2022 and $6m at the end of 2022 then the average AP is ($4m + $6m)/2 – $5m

Cost of Goods Sold (COGS) is the cost of goods sold over the financial year.  If XYZ Ltd has COGS of $100m then the DPO of XYZ Ltd is $5m/($100m/365) = 18.25 days.

It is useful to undertake some baselining of AP processes.  KPIs to measure include:

• Percentage of payments made before their due date
• Percentage of payments made after the due date
• Route cause analysis of early and late payments. This may highlight issues in the way invoices or GRNs are processed/approved within the organisation

Some suggestions to help extend Accounts Payable are:

• Automated system processes to ensure that payments are not made before their due date
  • Note, there may be some processing benefits in reducing the number of payment runs per week
• Use of credit card payments
• Extending payment terms may be possible. Supply Chain Financing (SCF) may assist in this process – but note that a number of European jurisdictions impose a maximum payment term.  Auditors will also review terms and conditions of SCF arrangements to ensure that the liability should not be reclassified as debt.

Summary CCC using the numbers calculated in the above examples:

Per the CCC definition, the Cash Conversion Cycle for Corporate XYZ Ltd is:

 CCC = DIO + DIO – DPO = 7 + 6 – 18 = -5

Check out the Treasury & Risk 5 minute webinar: Does Real-Time Really Matter?

The value of the Cash Conversion Cycle metric

Corporates like to analyze the trend of their CCC over time and to benchmark themselves against their peers.

The information provided is certainly of interest, but Corporates need to carefully interpret the metric to extract value from measure. There are so many factors that can explain variances between peers:

• Geographical differences in terms of markets served
• Different lines of business that are included in the consolidated results
• Different year-ends which result in different stock levels being held in relation to a corporate’s sales cycle.

Ultimately, the greatest value is provided by a corporate undertaking a baselining exercise to assess their current performance – thereafter, it is a matter of driving process improvement.  Potentially identifying and prioritizing quick wins.

Working capital process improvement

In terms of driving internal working capital improvements there are several factors to consider:

• Firstly, make sure that all subsidiaries are working to exactly the same definitions – this is especially true if the group has grown through acquisition.Examples of differences might be:
  • Excluding intercompany balances
  • Inclusion/exclusion of Spares within Inventory

• Secondly, in order to avoid year-end or quarter-end “window dressing” modify the formulas used for DIO, DSO and DPO and instead use rolling average Inventory, AR and AP figures over the past 12 months (ie take the monthly average of the past 12 months).

• Thirdly, set up a Working Capital Committee at subsidiary level.These committees should bring together Finance (AR & AP), Sales, and Production in order to ensure that working capital is taken into account in relation to corporate strategy.  An example might be a sales initiative of launching a sales promotion in the new year with the impact of having to build stock levels over the year end.  The pros and cons of these decisions need to be adequately assessed.

• Finally, but maybe most importantly, ensure that senior management Short Term Incentives (STIs)/bonuses include a measure of working capital performance.Subsidiary senior management bonuses are often only assessed on turnover or margin improvement.  A Subsidiary will not adopt the desired working capital practices unless they are compensated for their performance.

The impact of real-time data