Cash Conversion Cycle – CCC
What is the ‘Cash Conversion Cycle – CCC’
The cash conversion cycle (CCC) is a metric that expresses the length of time, in days, that it takes for a company to convert resource inputs into cash flows. The cash conversion cycle attempts to measure the amount of time each net input dollar is tied up in the production and sales process before it is converted into cash through sales to customers. This metric looks at the amount of time needed to sell inventory. the amount of time needed to collect receivables and the length of time the company is afforded to pay its bills without incurring penalties.
The CCC is also referred to as the “cash cycle.”
The metric is calculated as:
Where: DIO represents days inventory outstanding, DSO represents days sales outstanding and DPO represents days payable outstanding
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BREAKING DOWN ‘Cash Conversion Cycle – CCC’
Usually a company acquires inventory on credit, which results in accounts payable. A company can also sell products on credit. which results in accounts receivable. Cash. therefore, is not involved until the company pays the accounts payable and collects the accounts receivable. So the cash conversion cycle measures the time between the outlay of cash and the cash recovery. The CCC cannot be observed directly in cash flows, which are affected by financing and investment activities as well; rather, the cycle refers to the time span between a firm’s disbursing and collecting cash.
The calculation of CCC involves several items from financial statements for a certain period of time (generally 365 days for a year or 90 days for a quarter).
The formula for calculating CCC is as follows:
CCC = DIO + DSO – DPO
Days Inventory Outstanding (DIO) refers to the number of days it takes to sell an entire inventory. A smaller DIO is preferred. Days Sales Outstanding (DSO) refers to the number of days needed to collect on sales, or accounts receivable. A smaller DSO is also preferred. Days Payable Outstanding (DPO) refers to the company’s payment of its own bills, or accounts payable. By maximizing this number, the company holds onto cash longer, increasing its investment potential. Thus, a longer DPO is preferred.
For more information on the cash conversion cycle and its corresponding formula, see Understanding the Cash Conversion Cycle .
What It Means
The cash conversion cycle is a metric used to gauge the effectiveness of a company’s management and, consequently, the overall health of that company. The calculation measures how fast a company can convert cash on hand into inventory and accounts payable, through sales and accounts receivable, and then back into cash. By combining these activity ratios, the measurement indicates the efficiency of the management’s ability to employ short-term assets and liabilities to generate cash for the company. The CCC entails the liquidity risk associated with growth by measuring the length of time that a firm will be deprived of cash if it increases its investment in resources in an effort to elevate sales. It can be especially useful for investors who wish to draw a comparison between close competitors, as a low CCC signifies a well-managed company, and thus can be used to help evaluate potential investments. The CCC should be combined with other metrics, such as the return on equity and return on assets. as an indicator of management effectiveness and company viability.
While the term applies to companies in any industry, the cycle is extremely important for retailers and similar businesses, as their operations consist of buying inventories and selling them to customers. The metric does not apply to companies for which this is not the case, such as those in the software or insurance industries. The measure illustrates how quickly a company can convert its products into cash through sales. The shorter the cycle, the less time capital is tied up in the business process, and thus the better for the company’s bottom line.
An important distinction is that the cycle applies to firms that buy and sell on account, while cash-only firms only accommodate data from sales operations in the equation, as their disbursed cash is directly measurable as purchase of inventory, and their collected cash is measurable as sale of inventory. This direct ratio does not exist for firms that buy and sell on account. Changes in inventory occasion payables and receivables rather than cash flows, and increases and decreases in cash will discount these accounting vehicles from statements. Therefore, the CCC is calculated according to the cycle of cash through receivables, inventory, payables and, eventually, back to cash.
Why It Matters
The CCC measurement on its own does not carry much meaning. It should generally be used to track a company over several consecutive time periods and compared to multiple competitors. By tracking the CCC over time, patterns of bettering or worsening value can be more telling than a single period’s CCC value taken out of context. Similarly, comparing the CCC from one period to that of a competitor or multiple competitors can elucidate which company is succeeding in–and which is failing at–moving inventory, collecting payments and keeping cash on hand.
Based off of CCC reports, analysis of cash flow statements and liquidity position, companies can adjust their standard of credit purchase payments or cash collections from debtors. A company’s investment decisions can directly influence its CCC. In times of cheap credit, cash cycles have been slow to shorten, as it becomes more affordable for companies to borrow money toward their inventory investments. In fact, cheap debt has led large retailers and other similar companies to increase their debt loads by more than 60% since 2007 and, according to the Wall Street Journal. “By taking on more debt, companies can invest in operations, and fund dividends and buybacks, without having to generate cash any faster,” leading to stagnant CCCs across the board.
One exception to this trend, interestingly, is the cash cycle of online retailers. Frequently, because online retailers can pay their suppliers for goods after they receive payment for those goods from customers, they don’t need to hold as much inventory in house. And since they are still able to hold onto that cash for a longer period of time, they often actually wind up with a negative CCC. Amazon.com Inc. (AMZN) is a perfect example of this, wildly outperforming its retail competitors, such as Wal-Mart Stores Inc. (WMT), Target Corp. (TGT) and CostCo Wholesale Corporation (COST), in terms of the length of its cash cycle, if not overall revenue.
According to a Forbes calculation of a period running through 2012, Amazon “manages to hold inventory for 28.9 days plus 10.6 days to collect receivables or 40 days in total but then pays accounts payable in 54 days thus achieving a negative cash conversion cycle for Amazon.com of -14 days. You don’t see this that often but definitely a win for Amazon shareholders. Maybe not for the suppliers waiting for their checks.” While online retailers generally have this advantage over their brick-and-mortar counterparts, it is important to note that CCC should not be taken out of context, and should be used in conjunction with other metrics.