Cash conversion cycle (CCC)
Strategic perspective
Financial perspective
Key performance question this indicator helps to answer
How well are we doing at maintaining a healthy cash position?
Why is this indicator important?
A main reason why companies get into difficulties is not necessarily a lack of sales but the company running out of money in the bank (cash) to pay for the day-to-day costs of the business. An old business saying is that ‘cash is king’. With this recognition, a number of KPIs have been developed to assess a company’s cash position, generally known as ‘cash flow’. The cash conversion cycle (CCC) is such a measure.
The CCC metric assesses the length of time, in days, that it takes for an organisation to convert resource input into cash flow. It measures 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.
In essence the metric calculation captures three steps:
- the amount of time needed to sell inventory;
- the amount of time needed to collect receivables;
- the length of time the company is afforded to pay its bills without incurring penalties.
Also known as ‘cash cycle’, in simple terms CCC measures the time between the outlay of cash and cash recovery (that is when the account is actually paid and not when a sale is made).
The longer it takes to convert the initial outlay back into cash in the bank, the more it will reduce, or squeeze, a company’s cash availabilities. Conversely, a positive trend in the cash conversion cycle will add to a company’s liquidity.
Generally speaking, the lower the CCC number in days the better for the organisation (although there are caveats – see the tips and warnings section on page 65). A shorter CCC means greater liquidity, which translates into less of a need to borrow, more opportunity to realise price discounts with cash purchases for raw materials and an increased capacity to fund the expansion of the business into new product lines and markets. CCC is similar to ‘working capital ratio’ (see the next KPI).
How do I measure it?
Data collection method
Data for the CCC KPI are collected through analysing sales records, inventory levels, payments outstanding/paid by customers (days sales outstanding) and payments outstanding/paid to suppliers (days payable outstanding).
Formula
Measured in days, CCC is calculated as:
CCC = DIO + DSO − DPO
Where:
- DIO represents days inventory outstanding
- DSO represents days sales outstanding
- DPO represents days payable outstanding.
Frequency
Organisations typically measure CCC on an annual basis but might report it quarterly on a rolling annual basis.
Source of the data
The data are drawn from inventory levels, sales records and accounting data.
Cost/effort in collecting the data
All organisations must collect data for payments made/received and should keep good records of inventory levels, so there is little extra cost/effort in creating this KPI over and above that already expended.
Target setting/benchmarks
There are organisations that collect CCC benchmark data, which are often arranged according to industry sector. Perhaps the most useful example is the annual North American and European survey by REL Consultancy, which shows industry performance against the DIO + DSO − DPO KPI.
Example
Here we explain DIO/DSO and DPO and illustrate it through the fictitious company XYZ Corp.
DIO is computed by:
- Dividing the cost of sales (income statement) by 365 to get a cost of sales per day figure;
- Calculating the average inventory figure by adding the year’s beginning (previous year-end amount) and ending inventory figure (both are in the balance sheet) and dividing by 2 to obtain an average amount of inventory for any given year; and
- Dividing the average inventory figure by the cost of sales per day figure.
For XYZ Corp’s FY 2005 (in $ millions), its DIO would be computed with these figures:
| 1 | cost of sales per day | 4,800 ÷ 365 = 2.2 |
| 2 | average inventory 2005 | 620 + 700 = 1,320 ÷ 2 = 660 |
| 3 | days inventory outstanding | 660 ÷ 2.2 = 300 |
DIO gives a measure of the number of days it takes for the company’s inventory to turn over, i.e. to be converted to sales, either as cash or as accounts receivable.
DSO is computed by:
- Dividing net sales (income statement) by 365 to get a net sales per day figure;
- Calculating the average accounts receivable figure by adding the year’s beginning (previous year-end amount) and ending accounts receivable amount (both figures are in the balance sheet) and dividing by 2 to obtain an average amount of accounts receivable for any given year; and
- Dividing the average accounts receivable figure by the net sales per day figure.
For XYZ Corp’s FY 2005 (in $millions), its DSO would be computed with these figures:
| 1 | net sales per day | 3,500 ÷ 365 = 9.6 |
| 2 | average accounts receivable | 540 + 538 = 1,078 ÷ 2 = 539 |
| 3 | days sales outstanding | 539 ÷ 9.6 = 56.1 |
DSO gives a measure of the number of days it takes a company to collect on sales that go into accounts receivables (credit purchases).
DPO is computed by:
- Dividing the cost of sales (income statement) by 365 to get a cost of sales per day figure;
- Calculating the average accounts payable figure by adding the year’s beginning (previous year-end amount) and ending accounts payable amount (both figures are in the balance sheet), and dividing by 2 to get an average accounts payable amount for any given year; and
- Dividing the average accounts payable figure by the cost of sales per day figure.
For XYZ Corp’s FY 2005 (in $ millions), its DPO would be computed with these figures:
| 1 | cost of sales per day | 800 ÷ 365 = 2.2 |
| 2 | average accounts payable | 140 + 136 = 276 ÷ 2 = 138 |
| 3 | days payable outstanding | 138 ÷ 2.0 = 69 |
DPO gives a measure of how long it takes the company to pay its obligations to suppliers.
CCC computed:
XYZ Corp’s cash conversion cycle for FY 2005 would be computed with these numbers (rounded):
DIO 300 days
DSO + 56.1 days
DPO −69 days
CCC 287.1 days
Tips/warnings
It should be noted that shortening the CCC number does carry some risks. While an organisation could potentially achieve a negative CCC by always collecting from customers before paying suppliers, a policy of strict collections and lax payments is not always advisable. For instance, it can lead to the firm gaining a reputation as difficult to work with, which can negatively impact the ability to attract quality suppliers and so damage customer service.
Also, the CCC KPI is not an end in itself. It should be used as the starting point for performance improvement interventions, such as reducing inventory levels (so introducing techniques such as lean or just-in-time production) and techniques to smooth the accounts receivable process (such as improved customer relationship management).
References
www.investopedia.com/terms/c/cashconversioncycle.asp
www.investopedia.com/university/ratios/liquidity-measurement/ratio4.asp
M. Theodore Farris II, Paul D. Hutchison and Ronald W. Hasty, Using cash-to-cash to benchmark service level performance, Journal of Applied Business Research, 21(2), 2005. http://journals.cluteonline.com/index.php/JABR/article/view/1494
REL Consultancy: www.relconsultancy.com