Cash conversion cycle
The number of days between paying suppliers for inventory and collecting cash from the customers who bought it.
In short
- It combines three measures: days inventory outstanding, days sales outstanding and days payable outstanding.
- A shorter cycle means less cash tied up in running the business.
- It can be negative when customers pay before suppliers are paid.
Cash conversion cycle = DIO + DSO − DPO
Calculate all three over the same period using the same day count. Fewer days is generally better, as long as payables are not being stretched beyond agreed terms.
The cash conversion cycle measures how long a dollar spent on the business takes to come back as cash. It starts when the business pays for inventory or inputs and ends when the customer's payment arrives.
Its three parts
- Days inventory outstanding (DIO): how long goods sit before being sold.
- Days sales outstanding (DSO): how long customers take to pay after a sale.
- Days payable outstanding (DPO): how long the business takes to pay suppliers.
Inventory and receivables tie up cash; payables give some back. The cycle adds the first two and subtracts the third.
Reading it
A cycle of 60 days means the business has to finance about two months of operations from its own cash or borrowing. Shortening it, by selling inventory faster, collecting sooner or paying suppliers later within terms, frees up cash without increasing sales. Retailers that sell for cash before they pay suppliers can have negative cycles: their suppliers are effectively financing them.
Service businesses with no inventory can still use the idea, using just DSO minus DPO.
Worked example
A distributor's cycle
A hardware distributor holds inventory for 55 days, collects from customers in 40 days and pays suppliers in 35 days. Its cash conversion cycle is 55 + 40 − 35 = 60 days. Cutting inventory by 10 days through better purchasing would shorten the cycle to 50 days and release about 10 days of cost of sales in cash.