The cash flow cycle performance metric helps companies identify how long it takes to convert their inventories into cash. It measures this time in days. Some companies successfully tweak this to fit service industries, but finance professionals created the metric specifically for companies with physical inventories.
The Cash Conversion Cycle Ratio Formula
Before you begin your cash flow cycle calculation, there are formulas and terms with which you need to become familiar. These terms are part of the formula and should be calculated in advance:
1. Days Inventory Outstanding
Days inventory outstanding (DIO) measures the average number of days it takes your company to convert sitting inventories into sales. “Sales” refers to purchases but not necessarily the dates when clients pay.
DIO = (Average inventory/Cost of goods sold) x 365
2. Days Sale Outstanding
DSO (days sales outstanding) is the average number of days it takes companies to collect payment after a sale. It also expresses the final number in days.
DSO = (Average accounts receivable/Total credit sales) x 365
3. Days Payable Outstanding
Cash flow measures both income and expenses, so companies also need to determine how long it takes to pay their own invoices. This is DPO (days payable outstanding).
DPO = (Average accounts payable/Cost of goods sold) x 365
4. Cash Conversion Ratio
After calculating the three previous ratios, you can now put it all together to calculate the cash conversion cycle (CCC):
CCC = DIO + DSO – DPO
DIO = 20 days
DSO = 15 days
DPO = 20 days
CCC = 20 + 15 – 20 = 15
It will be 15 days to convert inventory investments into cash.
Note: When calculating CCC, the goal is to reduce the number over time. Decreasing the number indicates your inventory turnover rate is improving.
The Importance of Cash Flow Cycle Calculation
Whether a business survives, thrives or fails can be dependent on cash flow forecasting and management. Companies need cash to pay workers, pay suppliers, repay debts, innovate and expand. Credit can only pay for so much and ultimately must be repaid.
Two in-depth reasons this calculation is so important are:
1. Short-Term Financial Obligations
Every company has financial obligations, and some debts have legal ramifications. For example, employees must receive pay. Similarly, creditors require monthly payments, or they can recall loans, which can cause a business to default.
2. Long-Term Planning
It’s impossible to create long-term plans for your company without determining what the company can afford. Debt is an excellent supplement to cash, but it cannot replace it. Consequently, the health of cash flow determines the moves companies can make.
How Automating Accounts Receivable Affects Cash Flow
Calculating how quickly you convert inventory to cash is just one way to improve cash flow management. You also should determine ways to spend less time hassling clients for money. The easiest way to do this is to automate as many processes as possible and streamline communications. This leads to improved collections and cash flow.
Learn how Gaviti can make it happen.