Cash Conversion Cycle Explained

What does Cash Conversion Cycle mean and How is it calculated?
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In simple words, cash conversion cycle is a measure of the number of days it takes a business between paying cash for its inventory, to collecting cash from its customers.
So, if your business buys inventory and pays for it today, and sells and collects cash tomorrow, it means the cash conversion cycle of the business is 1 day. If your business collects cash from customers first, and pays for the products later, then it has a negative cash conversion cycle (e.g. if it collects cash from customers today, and will pay for the product in 3 days), then the cash conversion cycle is -3. So, is negative cash conversion cycle good? Yes, its great! because, in the example of negative 3 days, the business will have cash for three days that the business did not even need to generate from its own pockets, to pay for its vendors.
So the business is funded by customers. (Now this assumes business is making profit in sales. If the business is making loss on sales, ultimately the cost will catch up and will required the business to fund sales, but such a business should not continue).
Three components of Cash Conversion Cycle
Most businesses have credit arrangements with the vendors as well as customers. This means, when the business buys from the vendor, it does not have to pay immediately, and has a certain numbers of days from the invoice date, known as credit period, after which the business can pay without any additional charges or penalties. For a given business, how many days is that?, This is calculated as something called Days of Payables Outstanding. More on the calculation later.
Additionally, once purchased, the business may not be able to sell immediately. There may be a certain number of days for which the business needs to hold the inventory of products, before it can find and sell to a customer. Think of a business that sells leather bags. The business needs to buy and keep inventory in stock for some days (known as Inventory Holding Period, or Days of Inventory Outstanding). When a customer order is received, only then the business can make a sale and ship the product.
Now, the customer also expects certain number of days as credit period, before which they are not required to pay to the business. This is calculated as the Days of Sales Outstanding.
So, there are three components that impact the number of days it takes a business to complete a cash conversion cycle.
1) Days of Sales Outstanding
2) Days of Inventory Outstanding
3) Days of Payables Outstanding
Now comes the formula or calculation …
CCC (days) = Days of Sales Outstanding + Days of Inventory Outstanding - Days of Payables Outstanding
Or CCC = DSO + DIO - DPO
So Cash conversion cycle is the difference between the time it takes to pay for buying the inventory and time it takes to collect money after holding and selling the inventory. That is why the formula
DSO + DIO (days to hold inventory and collect cash from sales)
Minus
DPO (days available before business must pay)
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