The Cash Conversion Cycle: Definition, Formula & Example

Instructor: James Walsh

M.B.A. Veteran Business and Economics teacher at a number of community colleges and in the for profit sector.

This lesson will introduce you to the cash conversion cycle. it will be defined and a formula for its calculation is presented and explained. Finally a full illustration of the calculations is presented.

What is the cash conversion cycle?

Carla's Clothing is a mid-priced retailer of women's apparel. In order to stay competitive in a challenging retail environment, she is paying much closer attention to how she operates the day to day activities of her business. She is particularly interested in her cash conversion cycle.

The cash conversion cycle (CCC) simply measures how quickly dollars invested in her business return to her as profits. The main investment for Carla consists of purchasing inventory to sell to customers. Things get complicated though because inventory is usually purchased on credit from suppliers, so the cash doesn't go out when the inventory is ordered. When it is sold, customers can pay with cash or bank credit cards, but some others pay on store credit as well. Carla doesn't see that cash return until they pay.

How long her cash conversion cycle is depends on these three factors:

• The credit terms she gets from her suppliers which allow her to stretch payments for the inventory she buys.

• How long it takes her to sell the inventory. This is the most important item in the cash conversion cycle. Carla is not in the business of warehousing clothing. She really likes finding that perfect apparel item that delights a customer and gets her a sale! That is why she is in this business.

• How long it takes her credit customers to pay.

The faster the cycle goes the better it is for Carla!

Formula for the cash conversion cycle

From reading up online, Carla discovers there is a formula that makes calculating her CCC relatively easy. It is:

Cash conversion cycle (CCC) = Days inventory outstanding (DIO) + Days sales outstanding (DSO) - Days payables outstanding (DPO)

The three pieces of the formula relate to the three factors noted above.

Days inventory outstanding (DIO) is how many days it takes Carla to sell out her entire inventory. A lower DIO means that Carla's apparel is selling quickly.

Days sales outstanding (DSO) is the number of days needed for Carla to receive payment on sales. This isn't as important as it used to be now that most customers pay with bank credit cards. But Carla still has some of her favorite old customers using a Carla's store card and knows that most of them will pay within the 30 day grace period. A lower DSO means they are paying faster.

Days payables outstanding (DPO) concerns Carla because it is something she can control when she negotiates terms for inventory purchases. It is the grace period she gets to extend the number of days before she has to pay. She wants this number to be as high as possible.

Carla wants to start calculating her CCC frequently to see if it is getting better (less days) or worse (more days).

Cash conversion cycle calculation

Carla wants to calculate this for the year 2016. She needs to talk to her accountant and get the information to use in the formulas for each part of the calculation. Here are the results:

Accounting numbers for Carla
Carlas accounting numbers

Now she can get to work.

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