Understanding the Cash Conversion Cycle: How to Calculate and Use It for Small Business Success

Small businesses often face cash flow challenges, and one way to manage these challenges is by understanding and improving their Cash Conversion Cycle (CCC). The CCC measures the time it takes for a company to convert its investments in inventory and other resources into cash flow from sales. Below, we will explain how to calculate the CCC and provide an example of how keeping track of it can help small businesses.

How to Calculate the Cash Conversion Cycle

The CCC is a metric that measures a company’s liquidity by calculating the time it takes for a company to convert its resources into cash flow. It is calculated by adding the days inventory outstanding (DIO) to the days sales outstanding (DSO), and then subtracting the days payable outstanding (DPO). In other words, CCC = DIO + DSO - DPO. 

Days Inventory Outstanding is the average number of days it takes a company to sell its inventory. 

Days Sales Outstanding measures the average number of days it takes for a company to collect payment from its customers. 

Days Payable Outstanding represents the average number of days it takes a company to pay its suppliers.

For example, if a company has an average inventory of $10,000 and its cost of goods sold is $50,000, then its DIO would be (10,000/50,000) x 365 = 73 days. 

If the company has sales of $100,000 and its accounts receivable balance is $20,000, then its DSO would be (20,000/100,000) x 365 = 73 days. 

If the company has accounts payable of $15,000 and its cost of goods sold is $50,000, then its DPO would be (15,000/50,000) x 365 = 109.5 days. 

Therefore, the CCC would be 73 + 73 - 109.5 = 36.5 days.

How Tracking the Cash Conversion Cycle Can Help Small Businesses

Keeping track of changes to the Cash Conversion Cycle can help small businesses improve their cash flow and financial performance in several ways. For example:

Identify inefficiencies

By tracking the CCC, small businesses can identify areas of their operations that may be inefficient, such as slow-paying customers or suppliers with unfavourable payment terms. This information can help them make strategic changes to improve their cash flow.

Optimize inventory

By monitoring the DIO component of the CCC, small businesses can optimize their inventory levels to reduce the amount of cash tied up in excess inventory.

Improve cash flow

By reducing the DSO component of the CCC, small businesses can improve their cash flow by collecting payments from customers more quickly.

Negotiate better payment terms

By increasing the DPO component of the CCC, small businesses can negotiate better payment terms with suppliers, which can help them conserve cash.

It goes without saying that the faster a company can convert its resources into cash in the bank, the more successful it will be. By tracking your Cash Conversion Cycle over time, you can establish a current baseline and find ways to shorten it, if possible. If you have already found an optimal Cash Conversion Cycle for your business, then continuing to track it as a key performance indicator on an ongoing basis can prevent negative trends. However, in order to establish and track your Cash Conversion Cycle, you need to keep accurate sales, inventory, cost of goods, accounts payable and accounts receivable records.

At JAM Consulting Business Solutions, we understand that keeping accurate books can  be time consuming, let alone developing and monitoring liquidity indicators like the Cash Conversion Cycle. We can help you save time and set your business up for success—contact us today to find out how.