The term cash conversion cycle describes how long it takes a business (in number of days) to convert its inventory and other resources into cash flow resulting from sales. Although some organizations also refer to it as the cash cycle or net operating cycle, all mean the same thing. The purpose of a cash conversion cycle is to determine the length of time each dollar invested in production remains tied up to cover production costs before the inventory returns a profit.
Each company can tailor cash conversion cycle calculations according to its own unique needs. For example, the person calculating the figure should take into consideration the average time the business takes to turn over its inventory and collect payment from clients. He or she should also factor in how much time the business has to pay its accounts payable invoices before creditors begin assigning late fees.
The cash conversion cycle is just one of many metrics a company can use to help determine its profitability. It’s a good indication when a company posts steady or decreasing cash conversion cycles. However, it’s important to remember that the cash conversion cycle is only useful and applicable for companies that possess and manage a physical inventory.
Data Required to Determine a Cash Conversion Cycle
A business accountant will need to gather several pieces of data to calculate the cash conversion cycle for each quarter. These include:
- Accounts receivable and accounts payable on the first and last day of each quarter. This information is easy to find on the company balance sheet.
- Cost of goods sold (COGS) and revenue, which should be located on the company’s balance sheet. This refers to all costs involved with manufacturing and selling the company’s products.
- Exact number of days included in the calculation. That would be 90 days for the typical quarter but could be +/- a few days in either direction.
- Inventory on the first and last day of the quarter, also available on the balance sheet.
After obtaining this information, the formula to determine the cash conversion cycle is days inventory outstanding (DIO) plus days sales outstanding (DSO) minus days payable outstanding. DIO refers to the total number of days required to sell all inventory. The goal is to keep the number as low as possible. DSO describes the average number of days it takes to collect accounts receivable invoices. The number will be zero if the company only accepts cash payments at the time of delivery. However, this is uncommon. DPO describes the average number of days it takes a business to pay its bills. To obtain it, the accountant should divide the company’s average accounts payable invoice by its daily COGS.
Need More Metrics to Determine the Profitability of Your Business?
The cash conversion cycle is an important metric, but it’s only one of many that help to determine financial health. We invite you to review the accounting and bookkeeping services offered by Doerhoff CPA and then get in touch to let us know how we can help to improve the bottom line of your business.