The Cash Conversion Cycle, also known as the Net Operating Cycle, answers the question, “How many days does it take a company to pay for and generate cash from the sales of its inventory?” However, before an analysis like this can take place, it’s important to consider the company’s primary line of business.
If the company sells software, it’s more challenging to measure performance if it generates revenue primarily on intellectual property – by developing computer code and licensing its use to clients. For online marketplaces, especially those that make the majority of their profits from third-party sellers that manage product sourcing, listing their inventory and shipping products on their own won’t measure the online marketplace’s own inventory. Since these types of businesses don’t act like a manufacturer that produces and sells products to other businesses or the general public, this type of analysis will be less helpful.
To start with the formula for the Cash Conversion Cycle (CCC), it’s calculated as follows:
CCC = Days of Sales Outstanding (DSO) + Days of Inventory Outstanding (DIO) – Days of Payables Outstanding (DPO)
Days of Sales Outstanding, Defined
DSO is the average number of days it takes a company to collect payment once a sale has completed. The beginning and ending Accounts Receivable figures from a fiscal year are added together and divided by 2. Then revenue from the income statement for the entire fiscal year must be divided by 365 days to get a daily average.
DSO = Beginning Accounts Receivable + Ending Accounts Receivable / 2 = Revenue / 365 days
The fewer the days, the better; however, it can’t be so fast that such tight payment terms push customers away.
Days of Inventory Outstanding, Defined
DIO is the average number of days a business keeps its inventory before it’s purchased.
The beginning and ending inventories of a fiscal year are added together and divided by 2 to find an average. The resulting figure is then divided by the daily average of the cost of goods sold over a fiscal year, which is often 365 days.
DIO = Beginning Inventory + Ending Inventory / 2 = Cost of Goods Sold / 365 days
The lower the number, the faster inventory is sold. While there’s nothing wrong with moving it fast, there is the danger that orders might not be able to be fulfilled.
Defining the Operating Cycle
As the CFA Institute explains, putting DIO and DSO together constitutes the Operating Cycle. This is defined as the period of days that it takes a business to transform basic materials and/or goods into stock and obtain money from the completed transaction. When this number is small, it means product is moving and customers have no issue making prompt payments.
Days of Payable Outstanding, Defined
Days of Payable Outstanding determines the number of days a business takes to fulfill its debts to suppliers.
DPO = Beginning Accounts Payable + Ending Accounts Payable / 2 = Cost of Goods Sold / 365 days
Considerations for DPO include finding a balance between how long a business can take to pay their suppliers, but also not missing out on pre-payment discounts or being penalized with late fees, financing charges, etc.
Going Beyond the Results
When analyzing the Cash Conversion Cycle for the right type of company, it can provide great insight into a company’s efficiency in collecting billings; how long inventory is up for sale; and the time it takes to become current with its own suppliers. Depending on the results of the CCC analysis, performing financial analyses can provide insight into not only how the company is performing financially, but why the company is performing financially.
Sources
https://blogs.cfainstitute.org/insideinvesting/2013/05/21/a-look-at-the-cash-conversion-cycle/
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