The cash conversion cycle is one way to measure the effectiveness of the overall health of your company. There are three key data points to the equation:
- Days inventory outstanding (DIO)
- Days sales outstanding (DSO)
- Days payables outstanding (DPO)
This combination expresses the length of time in days that it takes to convert resource inputs into cash flow. The equation looks like this:
CCC = DIO + DSO – DPO
Since a company has its own liabilities and expenses to pay, the cash conversion cycle will look at how long it takes to convert inventory and accounts receivables into cash.
Ideally, a company wants to speed up their production process and sell goods as quickly as possible to reduce liability (inventory purchases, direct spend and operating debt) in order get cash from their receivables.
Additionally, if a company can slow down its payments to vendors for their inventory (increasing payment terms or pay as late as possible without incurring penalties), it will help overall cash flow and increase working capital.
By analyzing spend, companies will be able to attack this in a couple of ways:
1) A company can determine where spend is going and to which vendors;
- A company will understand which vendors have the best payment terms so they can push payments as long as possible to increase working capital and/or establish policies to use a preferred vendor so buyers use those with better terms.
- A company could also use this as a negotiating tactic with existing vendors to improve payment terms.
2) A company could use this as a sourcing opportunity if it doesn’t have a preferred vendor or vendor relationship today — when they go to market to source possible vendors, they would be able to negotiate improved payment terms.
All in all, a company should strive to have a shorter, rather than longer, cash conversion cycle as it helps to better measure how liquid its business really is.
