Cash conversion cycle
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The Cash Conversion Cycle or CCC represents how much time a firm needs to "redeem" (with profit), via cash collections from customers, the cash it previously "tied up" or "deposited" with suppliers. Thus, the CCC measures how long an investment with suppliers deprives a firm of cash, and how risky it would be to increase this investment in the course of expanding sales. However, shortening the CCC creates its own risks: while a firm could even achieve a negative CCC by collecting from customers before paying suppliers, a policy of strict collections and lax payments is not always sustainable.
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[edit] Basic equations
CCC (in days) = Inventory conversion period + Receivables conversion period – Payables conversion period
- Payables conversion period = (Avg. Accounts Payable/[+∆inventory +COGS])*365 = days holding accounts payable until it's all paid in cash (i.e. time before inventory growth hits cash)
- Inventory conversion period = (Avg. Inventory/COGS)*365 = days holding inventory until it's all sold
- Receivables conversion period = (Avg. Accounts Receivable/Sales)*365 = days holding receivables until the last cash collection
[edit] Derivation
The generic equation assumes a retailer: its suppliers deliver the inventory that its customers then acquire, and both transactions are at some point paid off credit. Thus, this firm regards the delivery of inventory as the first of four events that affect cash conversion through suppliers to customers: When inventory is delivered, it owes cash to suppliers ("accounts payable" and "inventory" grows); eventually, it disburses this cash ("accounts payable" fully subsides). It also is owed cash from customers when they acquire the inventory ("accounts receivable" grows & the firm accrues an equal "revenue"; "inventory" fully subsides & the firm accrues an equal "COGS" expense); later it collects this cash ("accounts receivable" fully subsides).
These four events suggest the three intervals that constitute the CCC. One of these begins with the inventory delivery, lasts while an "accounts payable" is held on the books, and ends with the cash disbursal. This is the "payables conversion period." Since cash is not tied up until the end of this interval, we get the CCC by subtracting it from the other two, which together constitute the firm's "operating cycle:" The "inventory conversion period" also begins with the inventory delivery, but lasts while it is held on the books and ends with its sale for a receivable; the "receivables conversion period" begins with the sale of inventory for a receivable, lasts while that receivable is held on the books, and ends when it is collected for cash.
We can calculate each of these three component intervals of the CCC -- how many days a firm keeps "inventory," "payables," and "receivables" on its balance sheet -- from our knowledge of their relationships with the income statement: Accounts Receivable grows only when revenue is accrued; and over the long run, the amount that Inventory shrinks and Accounts Payable grows is equal to the COGS expense (though this accrues later). Then, we use the equation TIME =LEVEL/RATE, i.e. we assume each of these intervals is roughly equal to the TIME needed for its LEVEL across the period to be achieved at its corresponding RATE. We estimate the "level across the period" as the average from balance-sheets surrounding the period, and its rate as the corresponding income-statement item for the period:
- Payables conversion period = the TIME needed to reach the period-average LEVEL of payables, at its corresponding (daily) RATE -- this rate being whichever items for the period that can increase "trade accounts payables," i.e. the ones that grew its inventory: [inventory increase + COGS]. NOTICE that we make an exception when calculating this interval: although we use a period average for the LEVEL of inventory, we also consider any increase in inventory as contributing to its RATE of change. This is because the purpose of the CCC is to measure the effects of inventory growth on cash outlays. If inventory grew during the period, we want to know about it.
- Inventory conversion period = the TIME needed to reach the period-average LEVEL of inventory, at its corresponding (daily) RATE -- this rate being the item that (eventually) shrinks inventory: COGS
- Receivables conversion period = the TIME needed to reach the period-average LEVEL of receivables, at its corresponding (daily) RATE -- this rate being the item that can grow receivables (sales): revenue
