Cash Conversion Cycle
Cash conversion cycle is the time it takes a company to convert its resource inputs into cash. It measures how effectively a company is managing its working capital.
|Cash Conversion Cycle = DSO + DIO − DPO|
Where DSO is days sales outstanding, DIO is days inventory outstanding and DPO is days payables outstanding.
It can also be calculated if we already know the operating cycle:
|Cash Conversion Cycle = Operating Cycle − Days Payables Outstanding|
Shorter the cash conversion cycle the better the company is off because it has to lock up cash for a relatively smaller period of time.
Company K has receivables turnover ratio of 12, inventory turnover ratio of 10 and payable turnover ratio of 8. Find the cash conversion cycle.
We first need to convert the turnover measures to number of days measures.
Days sales outstanding = 365/receivables turnover ratio = 365/12 = 30.42 days
Days inventory outstanding = 365/inventory turnover ratio = 365/10 = 36.4 days
Days payables outstanding = 365/payables turnover ratio = 365/8 = 45.63 days
Cash conversion cycle = DSO + DIO − DPO = 30.42 + 36.4 − 45.63 = 21.19
If the industry average cash conversion ratio is 25 the company is better off than other companies.