Minty Analyst EOOD

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What is the Cash Conversion Cycle

The Cash Conversion Cycle is a metric that tells us how long it takes the company to convert
capital invested in inventory back to cash.

Here’s a cool-looking process diagram to illustrate the cash conversion cycle:

Elements of the Cash Conversion Cycle

The Cash Conversion Cycle is a combination of several activity ratios, that we can use to analyze
a company’s performance.

DIO – Days Inventory Outstanding

The DIO ratio shows us the average time it takes to convert inventory into sales, the time a
company holds its inventory before selling it.
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DSO – Days Sales Outstanding

The DSO metric shows the average time the company takes to collect its receivables.

DPO – Days Payables Outstanding

The DPO shows us the average time it takes for the company to cover its payables to suppliers.

Considering the three ratios, the Cash Conversion Cycle shows us the time it takes to purchase
inventory/raw materials, sell inventory/finished goods, and collect the trade receivables from
the sales. Basically, the CCC calculation outlines the period between cash disbursements and
cash receipts.

Cash Conversion Cycle in Financial Analysis

The CCC formula aims to measure how efficient management is in running working capital. The
shorther the cycle is, the better.

Usually the Cash Conversion Cycle is analyzed over more than one period, so trends can be
identified. Doing so can show us whether working capital management is improving over time
or not.

We can use the Cash Conversion Cycle to benchmark the company against competitors, or
similar companies and industries.
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hi@mintyanalyst.com
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The Cash Conversion Cycle can’t be observed in the Cash Flow Statement, because of
investment and financing activities that introduction distortion in the provided information.

Analyzing CCC can help us to identify possible improvement options in cash management and
policies for credit sales and credit purchases. The metric is also very useful when comparing
businesses. For close competitors, the one with lower CCC is almost always in a better financial
position.

The Cash Conversion Cycle outlines how efficiently management is using short-term assets and
liabilities to generate cash, and helps potential investors to measure a company’s health.

Online retailers can go to a negative cash conversion cycle, when they negotiate terms where
they pay vendors after they have collected the trade receivables for the same goods.

Having bad credit history with suppliers slows down the Cash Conversion Cycle, as they won’t
give us access to bether credit terms. Poor collection of accounts receivable and piling up
inventory also slow down the CCC.

Uses in Forecasting and Modeling

Financial analysts use the Cash Conversion Cycle in building economic models for Discounted
Cash Flows (DCF) valuation, budgeting and forecasting.

We can also calculate the CCC over the historical data and use it to estimate Inventory,
Accounts receivable and Accounts payable. We achieve this by flipping the formulas from the
model. That way, we get the following three formulas: