For those that don’t know, the cash conversion cycle is a cash flow calculation that attempts to measure the time it takes a company to convert it’s investment in inventory and other resource inputs into cash. Why is that important you ask? A long CCC (Cash Conversion Cycle) can indicate liquidity issues as well as excess inventory on hand. This can be an indicator of poor sales or even worse, products that nobody wants.
The CCC is a combination of several activity ratios involving accounts receivable, accounts payable and inventory turnover; these ratios can be used to indicate how efficiently management is using short-term assets and liabilities to generate cash. This measurement is a good tool to help evaluate how management is using the assets of the company. It is important to note that all industries are different and have different average cycle times but in general a decreasing CCC or steady CCC is typically good while rising ones should raise some questions about asset management. The CCC is most effectively used with companies that deal with large amounts of inventory such as retailers.
The formula to calculate the cash conversion cycle of a business:
CCC = Days Inventory Outstanding + Days Sales Outstanding – Days Payable Outstanding