The cash conversion cycle is a cash flow calculation that quantifies how long it will take for a business to convert its investment in inventory into cash. To put it another way, the cash conversion cycle measures how long money is tied up in inventory. It is a useful number to calculate and a useful tool to use when projecting a small business’s cash flow.
Cash Conversion Cycle Components
To calculate the cash conversion cycle, add the days inventory outstanding to the days sales outstanding, and then subtract the days payable outstanding.
The days inventory outstanding, which is also called days sales of inventory, calculates how long it takes a company to turn its current inventory into sales. This number varies across industries, but generally a smaller days inventory outstanding is preferred. Calculate the days inventory outstanding by dividing average inventory by the cost of goods sold divided by 365.
The days sales outstanding measures the average number of days that it takes the company to collect the revenue from the sale. A low days sales outstanding figure means that it takes a company less time to collect its accounts receivable, while a high value indicates that the company takes a long time to collect its sales revenue. A low days sales outstanding is preferred. The days sales outstanding is the average accounts receivable divided by net credit sales divided by 365.
The days payable outstanding calculates how long it takes a company to pay its own bills and accounts payable. A higher number means that the company is holding onto its own cash for a longer amount of time, so a higher days payable outstanding is preferred. To find the days payable outstanding, divide the average accounts payable by the cost of goods sold, and then divide it by 365.
Example Cash Conversion Cycle Calculation
Assume a business needs to calculate its cash conversion cycle. Sales for the time period were $75,000, and $5,000 of merchandise was returned. Cost of goods sold on the net sales is $15,500. The average inventory was $1,400, and the average accounts receivable was $15,000. The average accounts payable was $4,000. The calculation of each component of the cash conversion cycle is as follows:
- Days inventory outstanding = $1,400 / ($15,500 / 365) = 32.97
- Days sales outstanding = $15,000 / (($75,000 – $5,000) / 365) = 78.21
- Days payable outstanding = $4,000 / ($15,500 / 365) = 94.19
The business’s cash conversion cycle is:
Cash conversion cycle = 32.97 + 78.21 – 94.19 = 16.99
This means that it takes the company about 17 days to pay for its inventory, sell it, and receive the cash from the sale. Knowing this number can help a business owner more accurately model and project cash flows on a monthly or quarterly basis.