You know the saying: It takes money to make money. Figuring out how much profit your organization is making on the money it is investing is, at the most basic level, the management accountant’s most fundamental job.
But there’s another question implied in that saying that can get overlooked: As a business, how long does it take to turn money into more money? Finance professionals need to know how to answer this question with an understandable, consistent formula.
If you are a finance professional, accountant, or CFO trying to gauge how effectively your company is managing its working capital—the money you’re using to make money—the cash conversion cycle is one metric you can use to measure the amount of time it takes your business to convert investment in inventory into cash sales.
Cash conversion cycle measures efficiency of working capital
Basics of cash conversion cycle
The cash conversion cycle formula is the number of days that it takes for an organization to convert its inventory into cash in hand. A more technical definition of the cash conversion cycle: How many days does it take to convert resources inputs into cash?
The cash conversion cycle—also sometimes called the net operating cycle—is an important part of cash flow management for finance professionals to understand because it measures how efficiently cash moves through a business. By capturing how quickly a company turns its inventory into sales and then into cash, organizations can improve the efficiency of their processes to improve cash flow and profitability.
By Drew Adamek
January 27, 2022
Amelia Kinsinger
Understanding the cash conversion cycle helps finance professionals evaluate how quickly their organizations are turning inventory investments into cash sales.
Calculating the cash conversion cycle
Cash conversion cycle measures efficiency of working capital
Understanding the cash conversion cycle helps finance professionals evaluate how quickly their organizations are turning inventory investments into cash sales.
Basics of cash conversion cycle
But how to practically calculate the cash conversion cycle? There are three elements for calculating the cash conversion cycle: days of inventory outstanding (DIO), day sales outstanding (DSO), and days payables outstanding (DPO).
The DIO is the amount of time a company holds its inventory before selling it. The DSO is how long it takes to collect the payment for sales, and the DPO is how long it takes you to pay your bills.
Taken together, these three measurements form the basis of the cash conversion cycle formula:
In other words, how long the inventory sits on the shelves, plus the number of days until you receive payment, minus the time it takes you to pay for the inventory.
After that cycle is complete, you now know how to gauge the efficiency of working capital. A shorter cash conversion cycle means a company is quicker, and more efficient at managing its working capital, while a longer cycle is an indication of less efficiency.
The cash conversion cycle can help CFOs guide their organization’s strategic decision-making process and pinpoint areas of improvement, such as creating quicker accounts receivable processes or implementing leaner inventory management.
It should be noted that the cash conversion cycle isn’t applicable for every company; it doesn’t apply for companies that deal in intangible goods and services, such as consulting, intellectual property, or creative services that don’t have physical inventory on the shelves.—DA
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Calculating the cash conversion cycle
cash conversion cycle =
DIO
DSO
DPO
+
-
In other words, how long the inventory sits on the shelves, plus the number of days until you receive payment, minus the time it takes you to pay for the inventory.
After that cycle is complete, you now know how to gauge the efficiency of working capital. A shorter cash conversion cycle means a company is quicker, and more efficient at managing its working capital, while a longer cycle is an indication of less efficiency.
The cash conversion cycle can help CFOs guide their organization’s strategic decision-making process and pinpoint areas of improvement, such as creating quicker accounts receivable processes or implementing leaner inventory management.
It should be noted that the cash conversion cycle isn’t applicable for every company; it doesn’t apply for companies that deal in intangible goods and services, such as consulting, intellectual property, or creative services that don’t have physical inventory on the shelves.—DA
Subscribe to the CFO Brew newsletter for the latest industry news and insights.
But how to practically calculate the cash conversion cycle? There are three elements for calculating the cash conversion cycle: days of inventory outstanding (DIO), day sales outstanding (DSO), and days payables outstanding (DPO).
The DIO is the amount of time a company holds its inventory before selling it. The DSO is how long it takes to collect the payment for sales, and the DPO is how long it takes you to pay your bills.
Taken together, these three measurements form the basis of the cash conversion cycle formula:
The cash conversion cycle formula is the number of days that it takes for an organization to convert its inventory into cash in hand. A more technical definition of the cash conversion cycle: How many days does it take to convert resources inputs into cash?
The cash conversion cycle—also sometimes called the net operating cycle—is an important part of cash flow management for finance professionals to understand because it measures how efficiently cash moves through a business. By capturing how quickly a company turns its inventory into sales and then into cash, organizations can improve the efficiency of their processes to improve cash flow and profitability.
You know the saying: It takes money to make money. Figuring out how much profit your organization is making on the money it is investing is, at the most basic level, the management accountant’s most fundamental job.
But there’s another question implied in that saying that can get overlooked: As a business, how long does it take to turn money into more money? Finance professionals need to know how to answer this question with an understandable, consistent formula.
If you are a finance professional, accountant, or CFO trying to gauge how effectively your company is managing its working capital—the money you’re using to make money—the cash conversion cycle is one metric you can use to measure the amount of time it takes your business to convert investment in inventory into cash sales.
Calculating the cash conversion cycle
