What is the cash conversion cycle?
The cash conversion cycle is a metric that measures the amount of time (usually in days) it takes for a company to convert its investments in inventory and other resources into cash flows from sales.
The cash conversion cycle is an important metric for businesses that work with large amounts of inventory and product sales. Short cash conversion cycles mean that a company’s inventory is spending less time in storage, and getting out into the market quicker. The less time inventory remains inside warehouses, the sooner inventory will be turned back into revenue and produce a tangible ROI.
Companies should continuously calculate the cash conversion cycle as they manage their inventory and assets. The longer a cash conversion cycle, the longer it takes for the company to get a ROI. Conversely, businesses that maintain a short cash conversion cycle operate more efficiently, and tend to be more financially stable and healthy.
Additionally, cash conversion flow considers the time it takes to pay the business’s bills without incurring any financial penalties.
This is a metric that does not have one singular “best” value. Because different products take differing amounts of time to manufacture and sell. The cash conversion cycle for a company that manufactures commercial airplanes is going to be incredibly different from a business that manufactures ice cream.
How to calculate the cash conversion cycle
A cash conversion cycle is calculated using the following formula:
- Cash Conversion Cycle = Days Inventory Outstanding + Days Sales Outstanding - Days Payable Outstanding
The “Days Inventory Outstanding” refers to the number of days it takes a business to sell its entire inventory. Generally speaking, the smaller this number is (fewer days), the shorter the cash conversion cycle, which is either better or worse for the health of your business depending on the circumstances.
“Days Sales Outstanding” is the number of days that it takes for a company to fully collect all the revenue from the sales. Typically, cash orders that are made at a brick and mortar store have a DSO number of 0, because the payment for the order is collected immediately. This number can grow higher depending on the type of payment that is used. If credit is used to pay for the goods or services, this will likely be a positive number. Generally speaking, a smaller number is once again much better.
“Days Payable Outstanding” is a metric that refers to the company’s payment of its own bills. It relates to the amount of money that is currently owed by a company to the suppliers of the goods used to manufacture the product that they are selling. Maximizing this number is beneficial because it shows that the company is holding onto the cash for a longer period of time, thereby increasing the potential for investment in the company.
How to analyze a cash conversion cycle
Understanding how to properly assess a cash conversion cycle is an essential part of conducting business operations. It shows the efficiency with which a company operates, and reveals which aspects of the sales cycle have room for improvement. You can diagnose issues and problems that could cost you in the long run, such as inefficient inventory management. Tracking the cash conversion cycle over a long period of time can help to show where your company’s productivity and efficiency can be improved.
Remember that the cash conversion cycle isn’t the only metric you should use to identify your company’s weakest and strongest areas for improvement.
There are no “good” or “bad” metrics for cash conversion cycles because a “good” or “bad” score is relative to industry, business type, and business goals. But any business can gain it can be helpful to observe the cash conversion cycle metrics of competing companies to
The duration of the cash conversion cycle
A shorter cash conversion cycle indicates that a company uses cash more efficiently to manufacture and sell goods. Companies with short cash conversion cycles are proficient at recovering cash from selling excess inventory while paying suppliers. In other words, a short cash conversion cycle means that a company’s management team can get a quick turnaround on invoices and other means of cash generation.
A longer cash conversion cycle is indicative of the opposite—a company suffering from excess inventory that it can’t sell and long periods between sending invoices and collecting outstanding accounts receivable. No company wants to be in this position of potential liquidity risk, which is why the cash conversion cycle is so important to calculate in the first place.
Most businesses maintain a positive cash conversion cycle. However, occasionally a company will reach a negative figure when calculating the cash conversion. This means the business is operating at a highly efficient level because it is turn inventory into sales very quickly, collecting cash from customers in a very short period of time, and paying back suppliers at a slower rate. Achieving a negative cash conversion cycle metric is often a sign that the company has done a good job negotiating terms with suppliers and aligning its revenue with its cost of goods sold (COGS). Needless to say, this can solve many operational issues and set a business up for success in the long term.
How Settle can shorten your cash conversion cycle
Every business wants to be highly efficient and optimize its cash flow. Developing an efficient cash conversion cycle not only supports operational and financial security, but ultimately, it boosts revenue generation. Companies that are able to free up working capital to grow their business (instead of having cash tied up inventory) watch their bottom line increase quarter after quarter. When it takes a company a long time to pay vendors, a domino effect occurs, creating operational headaches and tenuous relationships. Nobody likes getting late payments.
Settle Working Capital can help brands pay their invoices fast, shorten their cash cycles, and improve their liquidity positions. With Settle, companies can streamline the accounts payable process with upfront vendor payment, built-in payment scheduling, and centralized vendor management. Settle Working Capital is founder-friendly financing with competitive, transparent payment terms and AI-powered holistic underwriting, and flexible repayment schedules tailored to your business for better cash flow forecasting.
Settle is already changing the game for hundreds of brands—check us out and schedule a demo today.
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