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.
A practice question
The cash conversion cycle is calculated as:
- DIO + DSO + DPOWhy not: Adding payables days ignores that supplier credit reduces the time the firm's own cash is tied up.
- DIO - DSO + DPOWhy not: The signs are reversed: receivables days lengthen the cycle and payables days shorten it.
- DIO + DSO - DPO — correct
Days of inventory on hand plus days of sales outstanding give the operating cycle. Subtracting days of payables outstanding leaves the number of days the firm must finance its operations itself.
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.
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