Lesson 1 of 7 · All lessons in this module
- The operating cycle and the cash conversion cycleVideo lesson
- Shortening the cycle and the cost of trade creditVideo lesson
- Total and net working capital
- Liquidity and its primary and secondary sources
- Drags, pulls and liquidity ratiosVideo lesson
- Conservative, moderate and aggressive working capitalVideo lesson
- Short-term funding strategy
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Lesson 1 of 7 · 13 min
The operating cycle and the cash conversion cycle
The cash conversion cycle counts the days between paying suppliers and collecting cash from customers: the shorter it is, the less financing the business needs.
In short
- The operating cycle runs from buying materials, through production and sale, to collecting cash. Cash rarely moves at the same moment as the activity.
- Three balances track the timing gaps: accounts receivable (cash still to come from customers), inventory (goods not yet sold) and accounts payable (cash still owed to suppliers).
- Their average lives are days sales outstanding (DSO), days of inventory on hand (DOH) and days payable outstanding (DPO).
- Cash conversion cycle = DOH + DSO − DPO. It is the gap between cash going out to suppliers and cash coming in from customers.
- A short, or even negative, cycle is ideal. A cycle that is longer than peers' or lengthening over time is a warning sign.
Where the timing gaps come from
A business that makes and sells goods repeats the same loop: it buys materials, turns them into finished goods, sells them and collects the cash. This loop is the operating cycle, and a firm may run through it once a year or dozens of times.
The cash does not move in step with the activity. A supplier delivers today but is paid in five weeks. A customer takes the goods today but pays in a month. And some products sit in a warehouse for a long time before anyone buys them, aged spirits being the extreme case.
These gaps show up on the balance sheet. Cash the firm expects to receive within the cycle appears as a short-term asset, and cash it expects to pay out appears as a short-term liability.
| Account | What it is | Recognised when… | Removed when… |
|---|---|---|---|
| Accounts receivable | Amounts customers still owe | A sale is made on credit | The customer pays |
| Inventory | Cost of goods made or bought for sale | The firm takes ownership of goods | The goods are sold |
| Accounts payable | Amounts owed to suppliers | Goods arrive and payment is deferred | The supplier is paid |
Measuring the cycle in days
Analysts turn each balance into a number of days. DOH is how long goods sit in inventory, DSO is how long customers take to pay, and DPO is how long the firm takes to pay its suppliers. These are activity ratios; their details come later in the curriculum, but the idea is simply the balance divided by one day's worth of the related flow.
Inventory is bought, held for DOH days, sold, and then collected DSO days later. So the firm waits DOH + DSO days from receiving goods to receiving cash. The supplier, however, is paid after DPO days, which covers part of that wait.
The part that is not covered is the cash conversion cycle (CCC): DOH + DSO − DPO. It runs from the day cash leaves for the supplier to the day cash arrives from the customer. During that window the firm must fund payroll and other bills from somewhere else.
Think of DPO as an interest-free loan from suppliers. The CCC is the part of the operating cycle that the supplier loan does not cover, so the firm has to finance it with its own cash or with borrowing.
Short, long and negative cycles
A long CCC means cash invested in inventory comes back slowly, so the firm needs more financing for longer. Businesses that hold large stocks (drug makers, fashion wholesalers, distillers) tend to have long cycles.
A short CCC means the investment returns quickly. Service businesses with little inventory that are paid up front, such as airlines selling tickets in advance, tend to have short cycles.
A negative CCC is possible: customers pay before suppliers are paid. A fast-turning retailer that sells for cash or card, holds little stock and has strong bargaining power over many suppliers can collect sales weeks before its supplier invoices fall due. The suppliers effectively finance the business.
A long cycle can simply reflect the industry. What worries analysts is a cycle that is longer than competitors' or getting longer over time. That can signal weakening demand (stock piling up), customers in poorer financial health (slower payment) or lost bargaining power with suppliers (shorter DPO).
Formulas
- Cash conversion cycle
DOH = days of inventory on hand, DSO = days sales outstanding, DPO = days payable outstanding. Measured in days.
- Days from balances (activity ratios)
Each balance divided by one day's worth of the related flow. Receivables relate to sales; inventory and payables relate to cost of goods sold.
Worked examples
Example 1 CCC from given days
Nordhavn Tools A/S holds inventory for 55 days, collects from customers after 40 days and pays suppliers after 35 days. What is its cash conversion cycle?
Example 2 CCC from balance sheet amounts
Valmonte SpA reports annual sales of EUR 7,300 million and cost of goods sold of EUR 4,380 million. Receivables are EUR 600 million, inventory EUR 720 million and payables EUR 540 million. What is its cash conversion cycle?
Example 3 Comparing three issuers
A grocery chain has DSO 2, DOH 25, DPO 40. A software firm has DSO 45, DOH 0, DPO 20. A machinery maker has DSO 70, DOH 110, DPO 50. Rank their cash conversion cycles and explain the differences.
On the exam
Expect a direct CCC calculation from given days (sometimes from balances), an item asking which action shortens or lengthens the cycle, and questions on what a negative or lengthening cycle means.
- Adding DPO instead of subtracting it. Supplier credit shortens the cycle.
- Thinking a negative CCC is impossible or a sign of distress. It means customers pay before suppliers are paid.
- Believing cash or marketable securities on hand affect the CCC. They do not enter the formula.
- Judging a long cycle as bad in isolation. Compare with peers and with the firm's own trend.
Check yourself
Q1An issuer has days of inventory on hand of 48, days sales outstanding of 36 and days payable outstanding of 52. Its cash conversion cycle is closest to:
Q2Which of the following will most likely lengthen an issuer's cash conversion cycle?
Q3An analyst finds that a retailer has a negative cash conversion cycle. This most likely indicates that the retailer:
Q4An issuer has sales of 9,125, cost of goods sold of 5,475, receivables of 750, inventory of 900 and payables of 600. Its cash conversion cycle is closest to:
Q5An issuer's cash conversion cycle rose from 40 to 65 days while its peers' cycles were stable. This most likely signals:
Answer the 5 questions: +10 XP for each one you get right first time.
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