What’s the Cash Conversion Cycle?

Traditional liquidity measures — such as the current and quick ratios — presume that all current assets are immediately available to pay off current liabilities. But every business owner knows that’s not true; it takes time and effort to process inventory and collect receivables to pay off current liabilities.

That’s why it’s important to calculate your cash conversion cycle. It’s a combination of the following three working capital turnover metrics:

1. Days in receivables, plus
2. Days in inventory, minus
3. Days in payables.

The numerator for all three turnover ratios usually equals average balance for the year (for example, the sum of the beginning and ending account balance divided by two). However, seasonal businesses may prefer to use averages based on monthly amounts.

The denominators for the three turnover ratios are:

1. Annual net sales (noncash sales less returns and allowances) for days in receivables,
2. Annual cost of goods sold for days in inventory, and
3. Annual cost of goods sold (or net credit purchases) for days in payables.

The last step is to multiply each fraction by 365 days. For example, XYZ Company had a beginning accounts receivable balance of $900,000 on January 1, 2021, and an ending balance of $1.1 million on December 31, 2021. So, its average receivable balance was $1 million for 2021. The company reported $8 million in annual net credit sales in 2021. So, XYZ’s days in receivable ratio would be about 46 days [($1 million divided by $8 million) times 365 days].

Reducing your company’s cash conversion cycle

For years, companies have been working hard to reduce their cash conversion cycle with very efficient supply chain management.

For example, XYZ Company could lower its cash conversion cycle by:

• implementing a real-time invoicing process,
• providing incentives for customers to sign up for automatic payments,
• making smaller raw materials orders from a nimble, local supplier, and
• delaying payments to suppliers from 30 days to 40 days.

What are the benefits of lowering your CCC?

Lowering your cash conversion cycle allows business owners to

• lower debt requirements on the business,
• re-invest capital and
• maintain a healthy balance sheet.

This was considered best practice for many years, but are these policies now hampering your Company’s ability to meet customer demand?

What steps can you take to lower your cash conversion cycle while also reducing your order backlog and meet customer demand?

You might consider…

• Increasing inventory on hand to reduce lead times to ship product
• Asking customers for additional advanced deposits

Bear in mind that the right approach varies from company to company. There’s no one-size-fits-all solution that works from everyone.

Do you have a Financial Executive on your leadership team that can help drive business strategy in these uncertain times? If not, we can help.