The very essence of a business is to take cash on hand and spend it on business operations to generate more cash. Different businesses do this in different ways, but the process occurs in one form or another in all industries. Let’s take a warehouse club as an example. Warehouse clubs like Costco or Sam’s Club purchase large amounts of inventory which they then sell to customers at discounted, wholesale prices. Inventory is purchased on credit or with cash, then that inventory is sold to customers, and finally cash is collected from those sales. It is possible to measure the time that it takes for this entire process to occur using a calculated figure known as the cash conversion cycle (CCC). The shorter the cash conversion cycle, the faster a company can take its cash on hand to generate more cash. In light of this interpretation, the CCC provide insights into a company’s liquidity.
Cash Conversion Cycle
Let’s first start with the definition of the cash conversion cycle. It may seem intimidating at first, but after I explain the concept, this calculation should make perfect logical sense:
Cash Conversion Cycle (CCC) = Days Inventory Outstanding (DIO) + Days Sales Outstanding (DSO) – Days Payable Outstanding (DPO)
The calculation for the CCC involves 3 derived figures. Days Inventory Outstanding (DIO) represents the number of days worth of inventory that a company has stockpiled. Days Sales Outstanding (DSO) represents the number of days worth of sales that the company has not yet collected from customers. Finally, Days Payable Outstanding (DPO) represents the number of days worth of inventory that the company was able to purchase on credit. The first two figures, DIO and DSO, lengthen the cash conversion cycle, since cash tied up in inventory and cash that customers owe is cash that the company does not have on hand. The third figure, DPO, shortens the amount of time in the cash conversion cycle, since purchases made on credit are essentially short-term loans given by vendors to the company. This is why DPO is subtracted from the sum of DIO and DSO. A shorter cash conversion cycle is generally “A Good Thing.” A company that generates cash quickly will not struggle in paying its short-term debts.
Let’s now take a look at how each component is calculated:
Days Inventory Outstanding (DIO) = Average Inventory / (Cost of Goods Sold / 365)
Focus on the denominator first. Cost of goods sold represents the total price of what the company paid for in goods that it sold to customers within one year. Imagine a warehouse club purchases $50 million worth of goods which it then sold to customers for a total of $52 million. The total revenues generated would be $52 million, but the cost of goods sold would be recorded at $50 million, since the cost of goods sold is based on the price the company paid to purchase the goods, not the price at which they were sold. Cost of goods sold is measured for an entire year, so to figure the cost of goods sold per day, we divide by 365.
The numerator is the company’s average inventory, which can be calculated by taking the average of the beginning-of-year inventory and the end-of-year inventory. If we take the average inventory and divide it by the cost of goods sold per day, the result can be roughly interpreted as the number of days worth of inventory that the company has on hand. Generally speaking, the smaller this number, the better. Capital tied up in inventory is unavailable to the company. In the meantime, this inventory can lose value through obsolescence, spoilage, or theft. An effective manager will aim to keep the minimal amount of inventory necessary to handle business operations smoothly.
Days Sales Outstanding (DSO) = Average Accounts Receivable / (Sales / 365)
Once again, let’s look at the denominator first. Sales represents the annual revenue generated from the company’s main operations. We take this value and divide it by 365 to calculate sales per day.
The numerator, accounts receivable, is a result of the company making sales to customers on credit. To increase sales, many companies allow their customers to buy goods on credit to receive them today but not make payments until later. Accounts receivable is the total amount of money these customers owe the company. Here, we take the average accounts receivable and divide it by sales per day. The result can be interpreted as the number of days worth of sales that are still owed by customers and have yet to be collected.
Much like Days Inventory Outstanding, the lower Days Sales Outstanding (DSO) is, the better. If DSO is too large, it means that customers are delaying their payments for goods bought on credit. It is as if the customers received free loans from the company. A large DSO figure means that much of the company’s capital is tied up to loans made out to customers, which means the company has less cash on hand. This lengthens the cash conversion cycle and reduces liquidity. Therefore, a wise manager will do his best to lower Days Sales Outstanding. This might be done by insisting on cash payments for future purchases and by pressuring for the faster collection of receivables.
Days Payable Outstanding (DPO) = Average Accounts Payable / (Cost of Goods Sold / 365)
We previously covered how the denominator represents the cost of goods sold per day, so we will skip directly to the numerator. In addition to making sales on credit, a company can also make purchases on credit if it buys goods from vendors and delays the payment of cash. The total amount of cash owed to vendors for these purchases is the company’s accounts payable. Being able to purchase on credit is “A Good Thing” (now that the shoe is on the other foot!). Making purchases on credit means that less of a company’s capital needs to be tied up on inventory since they have, in essence, received a free loan from vendors. This freed cash can then be used for other purposes besides inventory.
Days Payable Outstanding is obtained by taking average accounts payable and dividing it by the cost of goods sold per day. This figure represents how many days worth of goods that the company has been able to purchase on credit. Unlike DIO and DSO, a wise manager will do his best to maximizing Days Payable Outstanding, as it actually shortens the cash conversion cycle. DPO is subtracted from rather than added to the other two figures. DPO can be increased by negotiating better deals with vendors.
Having explored each of the 3 derived figures, we can go back to our original definition of the cash conversion cycle to see how everything fits together:
Cash Conversion Cycle (CCC) = Days Inventory Outstanding (DIO) + Days Sales Outstanding (DSO) – Days Payable Outstanding (DPO)
As you can see, the cash conversion cycle is increased when more capital is tied up in inventory and accounts receivables, and it is decreased when vendors offer to let the company purchase goods on credit.
Many analysts seem to prefer liquidity ratios because they are easier to calculate, but the cash conversion cycle generally provides a more holistic (complete and comprehensive) picture of a company’s ability to quickly generate cash.