The cash conversion cycle (CCC) is a key way to measure your company’s health and efficiency. CCC is the term used to measure the number of days a company’s cash is tied up in inventories and accounts receivable. In other words, how long between cash outlay and cash recovery.
In theory, the more times you can cycle cash through your business per year, the greater the opportunity to produce profits. Let’s take a look at how to measure and improve your company’s CCC.
The Formula
Cash Conversion Cycle = DSO + DIO – DPO
- DSO is days sales outstanding = Average Accounts Receivable × 365 ÷ Credit Sales
- DIO is days inventory outstanding = Average Inventories × 365 ÷ Cost of Goods Sold
- DPO is days payables outstanding = Average Accounts Payable × 365 ÷ Cost of Goods Sold
The figures for credit sales, cost of goods sold, average accounts receivable, average inventories and average accounts payable can be obtained from the company’s financial statements.
What it Means
The ultimate goal in discovering your company’s cash conversion cycle is to improve it — to increase your company’s cash flow. A shorter cycle or quicker conversion is better. Understanding your company’s CCC can let you pinpoint the exact areas that need improvement to increase cash flow.
How to Lower Your CCC?
Let’s say you own a manufacturing company and you’re looking to improve your CCC. How would you go about this?
Lengthen DPO by Working with Suppliers
You can try to negotiate better payment terms with your suppliers. In many cases these are industry standard (net-30) payment terms, and it may be difficult to officially increase the amount of time you have to pay. But this option is worth exploring, especially if your supplier is heavily dependent on your business.
You don’t want to jeopardize your supplier relationships, but you also don’t need to pay faster than necessary. Last, shop for better terms with a comparable supplier if possible.
Shorten DIO by Focusing on Inventory
DIO can be improved in many ways. Raw materials, work in process and finished goods are all critical components of total inventory, which must be managed continuously for improved efficiency. For example, evaluate your raw material days on hand to be sure you’re not stockpiling too much.
All things being equal, you would rather have your suppliers holding your raw materials until you need them. As always, look for improvements in the manufacturing process to shorten production time.
Finally, optimizing quantities of finished goods on hand is an ever-present challenge, but it starts with having an accurate sales forecast and confidence in your manufacturing timetable.
Shorten DSO by Managing Receivables
You want your sales to convert to cash as quickly as possible, but competition likely forces you to sell on open credit terms — so manage it.
Send out your invoices as soon as the sale is complete. Follow up with your customer to be sure they’re satisfied and that they received the invoice. Offer a cash discount if they pay within a short time period; a common offer is a 2% discount if paid within 10 days. (A caution: Some customers will take the discount but not pay on time, defeating your purpose.)
Most importantly, have a process to professionally follow up with customers who don’t pay on time; you will gain respect and collect your money faster.
How Factoring Can Lower Your CCC
If you’ve done all you can to optimize your cash conversion cycle and still find yourself short on cash flow, you should consider factoring.
Factoring allows you to take control of your cash flow by discounting your invoices. At your discretion, you can sell your invoices for cash and immediately reduce your DSO when necessary to run your business more smoothly.
Take a look for yourself and see if your business could benefit from gaining full control of your DSO. Evergreen Working Capital has one of the most cost efficient and flexible factoring programs on the market.