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What is a Cash Conversion Cycle?

Of the many accounting parameters that matter to any company, an important one is the cash conversion cycle. Here's a brief explanation of the concept.
Omkar Phatak Jul 31, 2020
Running a successful business is a tough balancing act. One of the primary concerns is the maintenance of adequate cash flow, to smoothly run the business process ahead. Time and credit are two things that need to be used smartly to keep the business wheel rolling.
For a business to sustain itself, one needs a regular flow of cash, that can pay back credit and pay for inventory, to keep the business engine chugging ahead. An analysis of the whole time and money equation involved in running a business can be done using the concept of cash conversion cycle. It is a way of measuring the risk of cash crunch that a business puts itself in, when investing in new projects or expansion.

Definition

Also known as asset conversion cycle, it measures the amount of time required for a business to recover each dollar invested into it, to pay back the creditors and generate profit or cash. To put in simple words, it is the number of days required for a business to generate sales and recover its initial investment. It is made up of three prime parts, which measure the time required for three different stages of a business process.
The first temporal part is known as 'Days in Inventory (DIO)', which measures the time required for a company to develop and sell its products entirely. The second part is 'Days Sales Outstanding (DSO)', which measures the number of days taken by the company to collect its outstanding receivables, or to get payments for goods and services sold.
The third and last temporal part is 'Days Payable Outstanding (DPO)', which is a measure of number of days required by a company to clear the accounts payable or to pay back its creditors. To calculate the duration, you add up DIO and DSO, and then subtract DPO from it.

Formula

The formula that enables calculation for a 365-day financial cycle is as follows: 

Cash Conversion Cycle = [Days in Inventory (DIO) + Days Sales Outstanding (DSO) - Days Payable Outstanding (DPO)]
Where,
  • DIO = (Average Inventory Cost)/(Cost of Goods Sold Per Day)
  • DSO = (Accounts Receivable/Sales) x 365
  • DPO = Ending Accounts Payable/Cost of Goods Sold Per Day
A negative cycle duration means that a business is paying its creditors after it has recovered payments from its customers. For a business to run efficiently, shorter the cycle, better it is. This cycle duration is an important point when it comes to running any kind of retail or manufacturing business.
Most financial constructs track money or cash flow, while this cycle tracks the flow of money in the time dimension. For financial institutions providing credit and company managers, an analysis of this cycle is essential, to test business efficiency. When it comes to business, time is literally money and a streamlined cycle is what you need, to maintain consistent profits.