Running a business is all about making investments of time and money in exchange for a return on your efforts. But, if it takes too long for you to generate sales, you risk running out of cash. Or, if your production process takes too long, you risk leaving potential sales on the table.
The cash conversion cycle demonstrates how many days it takes for you to turn your investments in whatever it takes to create your products or services into cash flows from sales. It also helps measure how long it takes for you to see a return on your investment and can even help you spot inefficiencies along the way.
Because your cash conversion cycle (cash to cash cycle) helps tell you how much cash you need to fund ongoing operations, it’s instrumental when forecasting cash flow. Knowing the mechanics of your cash conversion cycle and using PayPie to forecast cash flow helps you see how efficiently you’re running your business and better anticipate your financing needs.
What is a cash conversion cycle?
You don’t need an MBA to decipher the benefits of increased sales. However, in the real world, you have to account for the amount of cash you have on hand to invest in inventory, employees, manufacturing, and the other costs of doing business.
Here’s where the cash conversion cycle helps. This measurement shows you how long you’ll go between making an investment in creating a product or service and turning it into a sale. Whether you buy inventory on credit or pay out of pocket or sell products on credit or cash-on-delivery, you can use the cash conversion cycle to measure how long it takes to turn your investment into an actual sale.
Your cash conversion cycle measures exactly how long it takes for you to turn investments into cash. This helps you make smarter financial decisions about inventory, sales, and pricing. A faster cycle means you’re churning out product as fast as you can sell it. A longer cycle means you’ll have to be a bit more careful about how you invest your money in inventory and expenses.
How to calculate your cash conversion cycle
Barry owns a ball bearing company. He wants to determine how long it’ll take for him to turn his investments in inventory and manufacturing into sales. The best way for him to do this is by calculating his cash conversion cycle —the time it takes between the outlay of costs to produce and when they’re sold.
To figure out his cash conversion cycle (CCC), Barry has to calculate several underlying components first: days sales outstanding (DSO), days inventory outstanding (DIO), and days payables outstanding (DPO).
With these numbers in hand, he can use this formula to figure out his cash conversion cycle:
CCC = DSO + DIO – DPO
Days Sales Outstanding (DSO)
DSO (days receivable or average collection period) reflects how long it takes for your customers and clients to pay their bills. The higher your DSO, the longer you go without getting paid for your sales. This can adversely affect your cash conversion cycle (and cash flow) since it means you have to wait longer to get a return on the money you’ve invested in making the product sold.
Days Inventory Outstanding (DIO)
Your DIO (days in inventory or days inventory) reflects how long it takes for you to sell an inventory item. The smaller your DIO, the faster you’re moving products. It also helps you determine how long it takes to convert investments into cash by reflecting the waiting period between your investments in inventory and how long it takes to sell the items.
To determine your DIO, you have to make two other calculations. You’ll want to determine your average inventory and cost of goods sold (COGS).
Average inventory lets you know the amount of unsold inventory you have at the end of every period. COGS lets you determine how expensive it is for you to create an inventory item. Here’s more on each:
Average Inventory measures the number of goods sold during a specific time period. Common average inventory measurements track two concurrent periods, providing you with insights into how long your products sit in the warehouse.
This figure helps you determine how quickly you’re able to move products — the more inventory you have at the end of the period, the slower your products move. And, inevitably, the longer your cash conversion cycle.
To calculate your average inventory, add the total value of your inventory for two or more periods, then divide by the total number of periods included.
For example, Barry has $10,000 in inventory left over at the end of September. He has $9,000 left over at the end of October. So Barry would add $10,000 and $9,000, then divide this figure by two. His Average Inventory is $950.
($10,000 + $9,000) ÷ 2 = $950
Your COGS represents how much it costs to acquire or manufacture goods during a particular period. This figure tallies up the cost of the inventory, labor and any other expenses that relate to producing a single unit of your merchandise. Think of this number as the underlying figure you have to factor into your sales price in order to cover the money you spent to produce something.
Barry wants to determine his COGS, so he collects information about his raw materials, labor, and other expenses. His inventory costs $5,000 per month, additional inventory purchases during the period ($750), and the remaining inventory at the end of the month ($1,500). Barry then adds his beginning inventory ($5,000) by the purchases made during the period ($750) minus his ending inventory ($1,500).
($5,000 + $750) – $1,500 = $4,250
With these average inventory and COGS in tow, you can now determine your DIO. For example, Barry has an average inventory of $950, which he then divides by his COGS figure of $4,250, broken out by day (roughly $141 per day on a 30-day cycle). His DIO is 6 days.
$950 ÷ ($4,250 ÷ 30) = 6.37 (rounded to 6 days)
Days Payables Outstanding (DPO)
DPO indicates how long it takes for your company to pay its bills to suppliers and vendors. You can calculate this figure quarterly or annually, depending on how detailed you want to get with your company’s cash outflow figures. The higher your DPO, the longer it takes for your company to pay its bills. A high DPO means you might have more financial wiggle room for making purchases (if you don’t have to pay vendors quickly), but could also indicate that you’re not paying vendors on time.
Adding it all up
Barry’s DSO is 45 days, his DIO is 6 days and is DPO is 30. Using the formula:
CCC = DSO + DIO – DPO
21 = 45 + 6 -30
Barry’s CCC is 21 days.
This means it takes Barry 21 days to go from production the production of goods to sales. By knowing where he stands, Barry can compare his metrics to benchmark standards for other ball bearing manufacturers. Internally he can also use his CCC as an internal reference point.
If he’s able to generate enough cash flow to make a profit and keep his operations humming, he knows that 21 days is a good CCC target. If this slips for any reason, he knows which factors to examine. When he wants to grow his business, he can look for further ways to optimize DSO, DIO and DPO.
Why the cash conversion cycle matters
The cash conversion cycle helps you determine how much money you can afford to reinvest in inventory. The underlying calculations can also help you spot inefficiencies from delinquent payments from customers, paying your own invoices too quickly, or letting poorly selling products languish on shelves for too long. All of these factors affect your cash flow and the money you have left to grow your business.
Whenever you need to apply for business financing, lenders will also look at your cash flow and cash conversion cycle in order to determine your ability to pay back the funds and on what terms. As you see that it took nearly 1,000 words to walk you through one calculation, that’s why PayPie has created a one-click risk assessment that includes cash flow analysis forecasting.
With PayPie, you can use your own financial data, the information you already have in your QuickBooks Online account, to generate your nearly real-time risk assessment and cash flow forecast. Get started today!
Create your PayPie account, connect your business and let our analytics dashboard do the rest.
This article is informational only. It is not financial advice. It does not replace the expertise that comes from working with an accountant, bookkeeper or financial professional.
Images via Pexels.