There are a number of ways to determine the health and value of a small business. You can review the company’s balance sheet to see its assets, liabilities, and owners’ equity. You could analyze its cash flow statement to determine how efficiently the business manages its liquidity. You could even analyze the company’s financial ratios, like gross profit margin or return on assets.
But for businesses that buy and manage a considerable physical inventory, one of the best health indicators you can monitor is the company’s cash conversion cycle.
What is the cash conversion cycle?
The cash conversion cycle is a metric that describes how quickly and efficiently a company converts its cash into sellable inventory, sells that inventory, then receives the cash back. Put another way, it’s the number of days between when a company buys inventory and receives the cash from the sale of that inventory.
Companies that have a quick cash conversion cycle tend to have greater liquidity because their cash spends less time tied up in unsold inventory and pending accounts receivable. These companies may also be more flexible, more efficient and more favorable to lenders. In most industries, a low cash conversion cycle score is the most desirable, while a higher score suggests a company is inefficient, less liquid and more risky to lenders.
How to use the cash conversion cycle
It’s important to note that the cash conversion cycle varies widely across different industries. In real estate, for example, the cash conversion cycle can be excessively long. But in retail, the cycle can be extremely short. To use the cash conversion cycle as a comparison metric, it’s best to look at companies with a similar product, market or model.
At Walmart, for example, the cash conversion cycle averaged just over 1.5 days from 2018-2020. Walmart has one of the shortest cycles in the retail sector. For comparison, Best Buy’s cash conversion cycle for the same period averaged just over 10.5 days. This shows that Best Buy has less liquidity and a slower inventory turnover.
While the cash conversion cycle is a valuable metric to monitor, it should be considered alongside a number of other business factors and health metrics. As a standalone data point, it doesn’t fully paint the picture of a company’s health. But when tracked over time, it can reveal important market trends — and potential red flags — at individual companies and within the industry.
What factors does the cash conversion cycle consider?
This simple number serves as a great health indicator because it incorporates a number of important data points into one easily comparable metric. The three main cash conversion cycle elements are:
Days of payables outstanding (DPO).
This number refers to how long a company has before it is required to pay off its inventory. Since many companies buy inventory on credit, this number can be fairly large. Unlike the DIO and DSO, which should be short, a long DPO is considered better because it gives the company greater liquidity and flexibility.
What is the cash conversion cycle formula?
The cash conversion cycle formula is simple:
Days of Inventory Outstanding + Days of Sales Outstanding – Days of Payable Outstanding = cash conversion cycle
Here’s how to determine each of the inputs for this formula:
Days of Inventory Outstanding:
(Beginning Inventory + Ending Inventory) ÷ 2
That answer is the company’s average inventory. Use this second formula to complete the DIO calculation:
Average Inventory ÷ Cost of Goods Sold
This answer is your final DIO number.
Days of Sales Outstanding:
(Beginning Receivables + Ending Receivables) ÷ 2
That answer is the company’s average receivables. Use this second formula to complete the DSO calculation:
(Average Accounts Receivable ÷ Net Credit Sales) x 365
This answer is your final DSO number.
Days of Payables Outstanding:
(Beginning Payable + Ending Payable) ÷ 2
That answer is the company’s average payables. Use this second formula to complete the DPO calculation:
Average Accounts Payable ÷ (Cost of Goods Sold ÷ 365)
This answer is your final DPO number.
As you can see, the cash conversion cycle is a simple formula to complete, but it requires a number of additional inputs. To determine the cash conversion cycle for your own business, you’ll simply need to reference your company’s balance sheet and income statement.
How can businesses improve their cash conversion cycle?
There are a number of ways businesses can improve this important metric. Any action that speeds up sales or payment collection, or allows the company more time to pay back its bills, will decrease its cash conversion cycle.
Here are a few tangible ways your business can improve its score:
- Incentivize customers to pre-pay or pay at delivery, reducing or eliminating your accounts receivable.
- Offer easy auto pay or online payment options.
- Optimize your inventory, decreasing the quantity of slow-moving items and better matching inventory levels to seasonal demand.
- Extend the time your company takes to pay suppliers (without exceeding your payment due dates!).
While a company can improve its cash conversion cycle, it’s important to remember that this metric is best used as a long-term tracking tool and considered alongside other health indicators. A low cash conversion cycle is a good sign, but not a perfect indicator of success.
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