Business Cash Conversion Cycle
When a business trades, it purchases goods, holds them as inventory, pays for the inventory, converts them to a product for sale and sells them on credit, and finally it collects the cash from the sale.
The cash flow cycle is the time period from when cash is paid out for inventory, to when cash is received from sales. The cash conversion cycle differs from the operating cycle as it allows for the accounts payable payment period. It measures the time between the payment for inventory and the receipt of cash from customers, whereas the operating cycle measures the time between purchasing the inventory and receiving cash from customers.
The cash conversion cycle and the operating cycle are shown in the diagram below.
Cash Conversion Cycle Formula
The cash conversion cycle formula is as follows:
Inventory Conversion Period
The inventory conversion period is the length of time from the purchase of inventory to the time the sales are made on credit.
Accounts Receivable Collection Period
The accounts receivable collection period is the average number of days it takes to collect accounts receivable. This is sometimes referred to the days sales outstanding or DSO.
Accounts Payable Payment Period
The accounts payable payment period is the average length of time between the purchase of inventory and the payment of cash to suppliers.
* If inventory levels remain fairly constant, cost of sales can be substituted for purchases in the equation above.
Cash Cycle Example
Suppose a business has the following information about sales, cost of sales, inventory, accounts receivable and accounts payable. The information can be used to calculate the cash cycle of the business.
|Account||Year 2||Year 1||Average|
|Cost of sales||1,260|
In this example the conversion cycle is calculated as follows:
Inventory conversion period = 230 / (1,260 / 365) = 67 days Accounts receivable collection period = 360 / (3,000 / 365) = 44 days Accounts payable payment period = 110 / (1,260 / 365) = 32 days Cash conversion cycle = 67 + 44 - 32 = 79 days
On average it takes 79 days from the payment for the inventory until the collection of cash from customers.
The longer the inventory period and the accounts receivable collection period and the shorter the accounts payable payment period, the longer the cash cycle of the business.
A long cash conversion cycle means cash is tied up in inventory and accounts receivable, offset by accounts payable. A business should aim to have as short a cash cycle as possible by reducing inventory levels (but not so far that inventory shortages appear), by improving accounts receivable collections and increasing the accounts payable payment period without upsetting suppliers.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.