Why Investors Should Look at the Cash Conversion Cycle of a Company

Every company juggles its receivables, inventory, and payables in different ways, and this is also determined, in part, by the nature and characteristics of the industry in which it operates. One method investors can use to determine how all of these attributes come together is to analyse the cash conversion cycle of a business. The formula is as follows:

Cash Conversion Cycle (CCC) = receivables turnover (days) + inventory turnover (days) – payables turnover (days)

Let’s now look at each component and how to make use of the CCC.

Receivables turnover days

This metric measures the average time it takes for a business to collect money from its debtors, and it’s a measure of the quality of customer collection from credit sales. Most businesses sell products and services on credit, and an average collection period may range from 60 to 90 days. The formula for computing this is:

(Net Credit Sales / Average Accounts Receivable) x 365 days

The smaller the number the better, as this means the business collects cash more quickly from its customers.

Inventory turnover days

Inventory turnover days represents the amount of time it takes to convert inventory to sales, and it’s a good measure of how fast inventory is able to be sold. Obsolete inventory may have high turnover days, or not be able to be sold at all, and this has negative implications for the business as it is stuck with inventory (incurring holding costs) it is unable to monetise.

The formula for this is:

(Cost of Goods Sold / Average Inventory) x 365 Days

The lower this number the better, as it means inventory is being converted to sales more quickly.

Payable turnover days

Payables turnover ratio measures the average time it takes for the business to pay off its suppliers for credit purchases. The formula is:

(Net Credit Purchases / Average Accounts Payable) x 365 Days

The larger this number the better, as this means suppliers are extending favourable credit terms to the business.

Cash conversion cycle days

Using the above three metrics, we can then compute the CCC for each business. The lower the CCC is, the better it is for the business, as it means cash is being converted at a faster pace. The CCC may even be negative, which essentially means suppliers are funding the company’s cash flows, and this is an even more advantageous situation for the company. Investors should compute and compare the CCC for the same company over five to 10 years to see if it has improved or deteriorated, as well as compare the CCC across companies within the same industry.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.