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The Cash Conversion Cycle

by Wayne A. Thorp, CFA

A recent issue of Computerized Investing explained how to measure a company’s ability to efficiently convert resources into cash flow and why this is important for investors. The relevant ratios used to measure the cash conversion cycle are described below.

For more of this article, see the Fundamental Focus column in the Second Quarter 2011 issue of Computerized Investing.

Calculating the Cash Conversion Cycle

Through the normal course of business, companies acquire inventory on credit, which they in turn use to create products. These products are then sold, oftentimes on credit. These actions generate accounts payable and accounts receivable, with no cash exchanged until the company collects accounts receivable and settles the accounts payable.

The cash conversion cycle (CCC) measures the time—in days—that it takes for a company to convert resource inputs into cash flows. In other words, the cash conversion cycle reflects the length of time it takes a company to sell inventory, collect receivables, and pay its bills. As a rule, the lower the number, the better. This is because, as the cash conversion cycle shortens, cash becomes free for a company to invest in new equipment or infrastructure or other activities to boost investment return. Also, the cash conversion cycle can be useful in comparing close competitors and assessing management efficiency.

The cash conversion cycle is actually a collection of three “activity ratios” related to the turnover in inventory (accounts receivable), all of which are expressed in days. The formula for the cash conversion cycle is as follows:

CCC = days inventory outstanding (DIO) + days sales outstanding (DSO) – days payable outstanding (DPO)

Days Inventory Outstanding

This measure addresses the question of how long—in days—it takes for a company to sell its entire inventory. The smaller the number, the better.

DIO = average inventory ÷ cost of goods sold per day

Where:
Average inventory = (beginning inventory + ending inventory) ÷ 2
Cost of goods sold per day = annual cost of goods sold ÷ 365

Days Sales Outstanding

Here we calculate the number of days a company needs to collect on sales. Cash-only sales have a DSO of zero, but many companies allow customers to buy on credit. Again, the smaller the number, the better.

DSO = average accounts receivable ÷ revenue per day

Where:
Average accounts receivable = (beginning accounts receivable + ending accounts receivable) ÷ 2
Revenue per day = annual revenue ÷ 365

Days Payable Outstanding

Lastly, we measure how long it takes for a company to pay its bills (accounts payable). The longer a company is able to hold its cash, the better its investment potential. In this case, a longer DPO is better.

DPO = average accounts payable ÷ cost of goods sold per day

Where:
Average accounts payable = (beginning accounts payable + ending accounts payable) ÷ 2
Cost of goods sold per day = annual cost of goods sold ÷ 365

Wayne A. Thorp, CFA, is senior financial analyst at AAII and editor of Computerized Investing. Follow him on Twitter @CI_Editor.

Wayne A. Thorp, CFA is a vice president and senior financial analyst at AAII and editor of Computerized Investing. Follow him on Twitter at @WayneTAAII.


Discussion

Roy from OH posted over 3 years ago:

Is this available on your site by industry type?
If so how do I find it?


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