Businesses fail for many reasons, but one of the most common is that they simply run out of cash.
Diespeker & Co has been supplying marble and stone to businesses and homes for more than 100 years. In recent years, costs have shot up at unprecedented rates, says Ollie Head, the company’s development manager.
Taking a close look at its stock and cash conversion cycle has enabled the company to minimise the impact of these price increases on customers, he says: “We have been able to absorb most of the increases in materials and shipping by minimising inventory stored in our workshop and buying stock that we know will sell more quickly."
Read on to learn more about the cash conversion cycle, how it's used and how to calculate it in your own business.
What is the Cash Conversion Cycle (CCC)?
The cash conversion cycle (CCC) is usually expressed in days and refers to the time taken to turn inventory into cash and to pay your suppliers.
Understanding your company’s CCC is important because it helps you quantify how quickly your company turns its products into cash.
The goal for business owners is to always have as low a CCC as possible. In general, this is achieved by minimising the time a company takes to convert inventory into cash and maximising the time it has to hold onto that cash before paying its bills - and boosting cash flow as a result.
How to calculate the cash conversion cycle
To calculate the cash conversion cycle of a business you need to know the number of days, on average, it takes to sell products in your inventory. You’ll then need to calculate how many days it takes to be paid for that sale, and how many days you take to pay suppliers.
For example, Diespeker & Co buy marble, granite and stone from all over the world. Materials must be paid for upfront but generally will only be paid for once a project is underway. “Our company works on large projects like stadiums, office buildings and shopping centres, so it can take many months before the project is complete and we’re paid in full,” says Head.
For this reason, the company buys more expensive stock only when it has been ordered by the customer and focuses inventory on more common products that are widely bought by domestic customers. “We always hold inventory of Carrara marble because it sells through more quickly compared to more expensive products,” says Head.
To understand the cash conversion cycle, it's first important to have a grasp of the following concepts:
Days of inventory outstanding
The number of days of inventory outstanding simply refers to how many days your current stock will take to sell on average.
The number of inventory days outstanding will depend on the type of business you run and the type of products you sell. For example, a company selling inexpensive t-shirts around a seasonal event could expect a low number of inventory days, whereas a business selling more expensive products that aren’t purchased frequently might have a higher number of inventory days outstanding.
Days sales outstanding
If someone buys a t-shirt from your retail outlet, for example, then you might collect cash immediately. However, for some businesses, payment is not received until after the customer receives goods – a time that’s measured using days of sales outstanding, or DSO.
In the case of Diespeker & Co, payment may not be received from a customer until after a project is completed. While the firm pays upfront for materials and then pays for labour and other business costs, it could be several months before these costs are paid for by the customer.
Days payables outstanding
The third element of the cash conversion cycle is ‘days payable outstanding’ which refers to the amount of time in days between receiving an invoice and settling payments to that supplier.
Reducing this metric can help your business to reduce overall CCC, meaning capital is available to reinvest in new stock and revenues more quickly, driving up overall profit. Using your American Express® Business Gold Card to pay supplier invoices can mean capital is available to invest back into the business while giving up to 54 days¹ of extended payment terms.
Cash conversion cycle formula
The cash conversion cycle formula is as follows:
CCC = days inventory outstanding (DIO) + days sales outstanding (DSO) - days payable outstanding (DPO)
Cash conversion cycle calculation example
Company A is a retailer that supplies boots to workers in restaurants and commercial premises. The company holds a large volume of stock since products are available in a wide range of colours and sizes and need to be provided to customers in fast timeframes.
- It takes the company an average of 28 days to turn over inventory: (DIO = 28)
- It takes a further 30 days to receive payment from customers: (DSO = 30).
- Meanwhile, it takes seven days for Company A to pay suppliers: (DPO = 7).
In this example, you would calculate the cash conversion cycle as below:
CCC = 28 (DIO) + 30 (DSO) – 7 (DPO) = 51 days
In this example, the cash conversion cycle is 51 days. Company A could reduce the cycle and increase available working capital in several ways. For example, the company could negotiate extended payment terms with suppliers. Increasing payment terms from seven days to 30 days would reduce the cash conversion cycle to 28 days.
How to use the cash conversion cycle
Your cash conversion cycle is a useful metric in determining how efficiently your business is using capital. A long cash cycle means the business is at a higher risk of running out of capital, or simply that the business isn’t fully realising its ability to drive growth and profits.
“Simply, a business that has a cash conversion cycle of 90 days does not have the opportunity to turn inventory into revenue and profit as often as a business with a cycle of 20 days,” says Catherine Erdly, a small-business expert and Founder of the Resilient Retail Club - a consultancy group that offers business support and development services.
One important thing to note about the cash conversion cycle is that it isn’t only applicable to a business but to individual product categories and services.
“It can be helpful to apply the 80/20 rule,” says Erdly. “If you know which products have the longest cash conversion cycle, then you can think about running promotions on that product to clear inventory, or you could invest more in a fast-moving product to generate more working capital for the business.”
Erdly recommends that businesses regularly review their cash conversion cycle to identify ways it might be optimised. In some cases, it may be possible to have a negative cash conversion cycle, where revenue is generated before a product is even made. “If you look at crowdfunding or Kickstarter campaigns, companies can potentially ask customers to pay before they have ordered raw materials or paid for labour,” she says.
1. The maximum payment period on purchases is 54 calendar days and is obtained only if you spend on the first day of the new statement period and repay the balance in full on the due date. If you'd prefer a Card with no annual fee, rewards or other features, an alternative option is available – the Business Basic Card.
