# Cash Conversion Cycle

When a business trades, it purchases goods, holds them as inventory, pays for the inventory, converts them to a product for sale and sells them on credit, and finally it collects the cash from the sale.

The cash flow cycle is the time period from when cash is paid out for inventory, to when cash is received from sales. The cash conversion cycle differs from the operating cycle as it allows for the accounts payable payment period. It measures the time between the payment for inventory and the receipt of cash from customers, whereas the operating cycle measures the time between purchasing the inventory and receiving cash from customers.

The cash conversion cycle and the operating cycle are shown in the diagram below.

 ← Purchased Paid → Sold → Received → Inventory period Accounts receivable period Accounts payable period Cash conversion cycle Operating cycle

## Cash Conversion Cycle Formula

The cash conversion cycle formula is as follows:

Cash conversion cycle = Inventory conversion period + Accounts receivable collection period – Accounts payable payment period

### Inventory Conversion Period

The inventory conversion period is the length of time from the purchase of inventory to the time the sales are made on credit.

Inventory conversion period = Inventory / Daily cost of sales = Inventory / (Annual cost of sales / 365)

### Accounts Receivable Collection Period

The accounts receivable collection period is the average number of days it takes to collect accounts receivable. This is sometimes referred to the days sales outstanding or DSO.

Accounts receivable collection period = Accounts receivable / Daily sales = Accounts receivable / (Annual sales / 365)

### Accounts Payable Payment Period

The accounts payable payment period is the average length of time between the purchase of inventory and the payment of cash to suppliers.

Accounts payable payment period = Accounts payable/ Daily purchases = Accounts payable / (Annual purchases / 365)

* If inventory levels remain fairly constant, cost of sales can be substituted for purchases in the equation above.

## Cash Cycle Example

Suppose a business has the following information about sales, cost of sales, inventory, accounts receivable and accounts payable. The information can be used to calculate the cash cycle of the business.

Cash conversion cycle
Account Year 2 Year 1 Average
Sales 3,000
Cost of sales 1,260
Inventory 200 260 230
Accounts receivable 380 340 360
Accounts payable 105 115 110

In this example the cash conversion cycle is calculated as follows:

```Inventory conversion period = 230 / (1,260 / 365) = 67 days
Accounts receivable collection period = 360 / (3,000 / 365) = 44 days
Accounts payable payment period = 110 / (1,260 / 365) = 32 days
Cash conversion cycle = 67 + 44 - 32 = 79 days
```

On average it takes 79 days from the payment for the inventory until the collection of cash from customers.

The longer the inventory period and the accounts receivable collection period and the shorter the accounts payable payment period, the longer the cash cycle of the business.

A long cash conversion cycle means cash is tied up in inventory and accounts receivable, offset by accounts payable. A business should aim to have as short a cash cycle as possible by reducing inventory levels (but not so far that inventory shortages appear),  by improving accounts receivable collections and increasing the accounts payable payment period without upsetting suppliers.

Cash Conversion Cycle November 6th, 2016

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