Work out the cash conversion cycle and explain what it shows
The idea
The cash conversion cycle measures how long a company's own cash is tied up in operations: CCC = days of inventory on hand + days of sales outstanding - days of payables outstanding. DIO = inventory / COGS x 365, DSO = receivables / revenue x 365 and DPO = payables / COGS x 365. A shorter cycle means less working capital to finance; a negative one means suppliers are funding the business, common among retailers that sell for cash before paying for stock. Faster collection or quicker inventory turnover shortens the cycle, and so does paying suppliers later, though stretching payables can strain relationships. Compare issuers within the same industry, since business models differ, and look at each component, not just the total.
Formulas
Days of inventory, receivables and payables
DIO = A_I ÷ C × 365; DSO = A_R ÷ S × 365; DPO = A_P ÷ C × 365
- DIO
- days of inventory on hand
- DSO
- days sales outstanding
- DPO
- days payables outstanding
- A_I
- average inventory, the mean of the start-of-year and end-of-year balance
- A_R
- average receivables, the same way
- A_P
- average payables, the same way
- C
- cost of goods sold for the year
- S
- revenue for the year
Inventory and payables are measured against cost of goods sold, receivables against revenue.
Cash conversion cycle
CCC = DIO + DSO − DPO
- CCC
- the number of days the firm's own cash is tied up
- DIO
- days of inventory on hand
- DSO
- days sales outstanding
- DPO
- days payables outstanding
Shorter is better: less cash must be financed. It can be negative when suppliers fund the business.
A practice question
A company has days of inventory on hand of 40, days of sales outstanding of 35 and days of payables outstanding of 30. Its cash conversion cycle is:
- 45 days - correct
- 105 daysWhy not: This adds payables days instead of subtracting them.
- 35 daysWhy not: This subtracts receivables days and adds payables days, reversing both signs.
Cash conversion cycle = DIO + DSO - DPO = 40 + 35 - 30 = 45 days. The operating cycle is 75 days, of which suppliers finance 30.
A harder one
A company has annual revenue of 7,300, cost of goods sold of 5,475, receivables of 800, inventory of 900 and payables of 600. Using a 365-day year and COGS for inventory and payables, its cash conversion cycle is closest to:
- 70 daysWhy not: This calculates days payable on revenue, understating DPO at 30 days instead of 40.
- 60 days - correct
- 45 daysWhy not: This calculates days of inventory on revenue, giving 45 days instead of 60.
DSO = 800/7,300 x 365 = 40. DIO = 900/5,475 x 365 = 60. DPO = 600/5,475 x 365 = 40. Cash conversion cycle = 60 + 40 - 40 = 60 days.
The hardest tier
Issuer A has DIO of 50, DSO of 30 and DPO of 45. Issuer B has DIO of 20, DSO of 25 and DPO of 60. Which statement is most accurate?
- B's cycle is -15 days, so suppliers fund it - correct
- A's cycle is -15 days, so suppliers fund itWhy not: This attaches B's figures to A; A's cycle is 50 + 30 - 45 = 35 days.
- B's cycle is 105 days, the longer of the twoWhy not: This adds B's payables days instead of subtracting them.
A: 50 + 30 - 45 = 35 days. B: 20 + 25 - 60 = -15 days. B collects cash from customers before it pays suppliers, so its suppliers finance its operations, while A must finance 35 days itself.
In the app: 9 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
Take the free diagnostic →