The cash conversion cycle

How long is cash tied up in the business?

A company buys or makes inventory, sells it (often on credit) and later collects the cash. The time from buying to collecting is the operating cycle . Suppliers usually let the company pay later, so cash leaves after the stock arrives. The cash conversion cycle (CCC) is the gap between paying suppliers and collecting from customers.

It is built from three day counts, called activity ratios : days of inventory on hand (DOH) , days sales outstanding (DSO) and days payable outstanding (DPO) . Inventory and receivables hold cash up, so they add days. Payables are supplier financing, so they take days away.

$$\text{CCC} = \text{DOH} + \text{DSO} - \text{DPO}$$

The operating cycle is DOH + DSO. The cash conversion cycle is the operating cycle less DPO. The longer the CCC, the longer the company must finance payroll, rent and other bills before customers pay.

How are the three day counts calculated?

Each day count divides a balance-sheet item by a daily flow from the income statement. Use 365 days unless the question says otherwise. The pairing matters. Receivables arise from sales, so DSO uses sales. Inventory and payables are carried at cost, so DOH and DPO use cost of goods sold (COGS).

$$\text{DSO} = \frac{\text{Accounts receivable}}{\text{Sales} / 365}$$

$$\text{DOH} = \frac{\text{Inventory}}{\text{COGS} / 365}$$

$$\text{DPO} = \frac{\text{Accounts payable}}{\text{COGS} / 365}$$

Go deeper Average balances, and the link to turnover ratios

Some analysts use average balances (the mean of the opening and closing figures) in place of year-end balances, because a year-end figure can be unrepresentative for a seasonal business. If a question gives a single balance, use it. If it gives opening and closing balances and asks for averages, use the average.

Day counts are the turnover ratios turned into days. Receivables turnover is sales ÷ receivables, and DSO = 365 ÷ turnover. Halden’s turnover is 730 ÷ 80 = 9.125 and 365 ÷ 9.125 = 40 days. The same relationship holds for inventory turnover (DOH) and payables turnover (DPO). The financial statement analysis topic covers these ratios in depth, and there payables turnover is built on purchases (cost of goods sold plus the increase in inventory) rather than on cost of goods sold. If a question gives purchases, use them for DPO; otherwise use cost of goods sold, as here.

How can a company shorten the cycle?

Each of the three day counts has its own lever. The aim is to release cash that would otherwise sit in inventory and receivables.

Shorten the cash conversion cyclefree cash from operations

• Lower DOH Use it sell inventory faster
  • Drop slow lines low or niche demand
  • Just-in-time deliveries more frequent supplier drops
  • Better demand forecasts data analytics
• Lower DSO Use it collect faster
  • Prompt-payment discounts reward early payers
  • Late fees and tighter credit screen customers
  • Deposits, installments, collectors cash up front
• Raise DPO Use it pay suppliers later
  • Longer supplier terms negotiate
  • Preferred-supplier deals volume for terms
  • Watch the cost higher prices, lost discounts

Lever	Actions	Watch out
Lower DOH	drop slow products, just-in-time deliveries, better demand forecasts	stock-outs and lost sales
Lower DSO	prompt-payment discounts, late fees, tighter credit, deposits, collection agencies	lost sales to easier-credit rivals
Raise DPO	negotiate longer terms, preferred-supplier deals	higher prices, forgone discounts, depends on bargaining power

Raising DPO has a catch. Suppliers often offer a discount for paying early, so paying late can be an expensive way to borrow. The last lesson of this module puts a number on that cost.

Exam tip Faster collection, faster selling and slower paying all shorten the cycle. Anything that holds more stock or pays suppliers earlier lengthens it.

What does a long or negative cycle tell you?

A long cycle can simply reflect the business. A company that keeps a large range of stock for long periods (a drug maker or a spirits maker) will have high DOH. What worries analysts is a cycle that is longer than peers’ or lengthening over time. It can signal weaker customer demand, customers of poorer credit quality, or lost bargaining power with suppliers.

A cycle can also be negative. That happens where customers pay at once (cash or card) and the stock turns over quickly while suppliers wait for weeks. Some retailers work like this, and airlines, paid in advance for most tickets, run very short cycles. The suppliers’ money pays for the operations, so cash is released rather than tied up.

Go deeper Why some industries carry long cycles

DOH is long where the product takes time to make or must be held in quantity: aged spirits, some pharmaceuticals, heavy machinery. DSO is long where customers are businesses that buy on 30 to 90 day terms. DPO is long where the buyer is large enough to dictate terms. A manufacturer that sells to businesses can therefore combine a long DOH and a long DSO, and only a strong DPO will keep its cycle moderate. Compare a company with its own industry, not with every industry.

What is working capital, and what is net working capital?

Working capital measures how much money the short-term operations need. Total working capital is a broad figure: all current assets minus all current liabilities.

$$\text{Total working capital} = \text{Current assets} - \text{Current liabilities}$$

Net working capital removes the items that belong to financing rather than to day-to-day operations. On the asset side it leaves out cash and marketable securities. On the liability side it leaves out short-term and current debt. What remains is mostly receivables, inventory and similar assets, less payables and accrued expenses.

$$\text{NWC} = (\text{CA} - \text{cash} - \text{securities}) - (\text{CL} - \text{short-term debt})$$

Working capitalshort-term assets less short-term liabilities

• Total working capital Memorize current assets minus current liabilities
  • Includes cash and securities every current asset
  • Includes short-term debt every current liability
• Net working capital Memorize operating items only
  • Excludes cash and marketable securities financing side
  • Excludes short-term and current debt financing side
  • Compare as % of sales long cycle, high ratio

Size makes raw working capital hard to compare, so analysts divide by sales. A long cycle goes with a high ratio of net working capital to sales, and a short cycle with a low ratio. A business with a negative cycle can even have negative net working capital.