Cash Conversion Cycle: Definition, Formulas, and Example

operating cycle formula

Your company’s operating cycle provides a gauge of how long it has cash tied up in operations, which is why it’s also commonly referred to as the cash conversion cycle. The cash conversion cycle is a cash flow calculation that attempts to measure the time it takes a company to convert its investment in inventory and other resource inputs into cash. In other words, the cash conversion cycle calculation measures how long cash is tied up in inventory before the inventory is sold and cash is collected from customers.

operating cycle formula

The cash conversion cycle can be a useful metric that tells investors how fast a company converts manufacturing inventory into cash. Investors prefer companies to have a shorter cycle, but the CCC is not necessarily a gauge of business performance, especially when comparing businesses from different industries. It is possible to have a negative cash conversion cycle which means that the business is collecting money for inventory before paying for it. This is seen when companies presell a product to determine the interest in the product and fund the purchase of the inventory. A negative CCC is an even more appealing trait than a low positive indicator.

Step 3: Calculate Days Payable Outstanding

In retail, this allows for items to be sent from the manufacturer or wholesaler before any actual money is exchanged, allowing for time to generate sales revenue. There are several ways brands can improve their cash-to-cash cycle time, including optimizing inventory and making operations leaner. The cash-to-cash cycle is important to financial performance because it sets expectations between vendors and carriers by establishing regular, predictable payments. Keeping track of cash flow and understanding where a brand’s cash is tied up and for how long is critical to strong financial performance. That means that the time between the initial investment (purchasing inventory) and the final returns (sales revenue) is short.

operating cycle formula

This means that companies can reduce or eliminate slow-moving or obsolete inventory, which in turn reduces the cost and time needed to dispose of these items. Capitalizing on your operational efficiency can have positive effects that are felt throughout the rest of your business. The companies with high operational efficiency are typically those that provide goods or services with short shelf lives i.e., clothing, electronics, etc. An efficient operational process can also help reduce other costs like marketing, finance, etc.

Enable your customers to pay their due

The Days Inventory Outstanding (DIO) metric is a measure of the average amount of time it takes you to purchase inventory and sell it as a final product. An operating cycle is the difference in days between the sale of a good from inventory and the days it takes to receive payment on that sale. This is used to determine how many days it takes to turn the inventory to sales, with the DIO indicating the number of days Kathy holds onto the inventory before it is sold. The CCC is sometimes referred to as the net operating cycle or the cash cycle. This ratio is more important if you purchase and move your inventory on a regular basis.

  • A higher, or quicker, inventory turnover decreases the cash conversion cycle.
  • For example, imagine Company X’s CCC for the fiscal year 2021 was 130, and its direct competitor Company Y had a CCC of 100.9 days.
  • The Operating Cycle is calculated by getting the sum of the inventory period and accounts receivable period.
  • It could lead to more accurate sales forecasts of the top-selling products and better decisions on the number of raw materials or inventory required.
  • He is a CFA charterholder as well as holding FINRA Series 7, 55 & 63 licenses.

In this way, the cash conversion cycle can be viewed as a sales efficiency calculation. It shows how quickly and efficiently a company can buy, sell, and collect on its inventory. The typical length of the cash conversion cycle will vary considerably between different industries meaning there is no single figure that represents a ‘good’ or ‘bad’ cash conversion cycle. However, it can be useful to compare the CCC of two companies within the same industry, as a lower CCC may indicate that one company is managing its working capital more effectively than the other. It can also be useful to track the CCC of an individual company over time, as this can demonstrate whether the business is becoming more or less efficient. If your business does not have inventory, the CCC isn’t going to be as useful.