How the Cash Conversion Cycle (CCC) helps manage liquidity issues

Many businesses will face liquidity challenges at some point in their life cycle. Whether it is a global pandemic, competing investment needs, or decreased sales due to fundamental changes in the market, these challenges make preserving cash through managing inventory, receivables, and payables a critical weekly (or daily) task. When you’re in this situation, you need a strong understanding of your cash conversion cycle (CCC) to be able to navigate through turbulent times effectively.

Cash Conversion Cycle (CC) Defined

The CCC measures the time it takes for a company to convert its investments in inventory into cash flows from sales. Three components and three related ratios are used to analyze your CCC: (1) Inventory/Days Inventory Outstanding (DIO), (2) Receivables/Days Sales Outstanding (DSO), and (3) Payables/Days Payable Outstanding (DPO). DIO measures how long it takes you to convert inventory into a sale. DSO measures how long it takes you to collect your sales. DPO measures how long it takes you to pay your suppliers for the inventory. Mathematically, your CCC is DIO + DSO - DPO. The number of days it takes for you to turn inventory purchases into cash is the sum of how long it takes you to sell the inventory plus how long it takes you to collect cash from the sale less the number of days you are paying off your suppliers.

Importance of Your CCC

This critical metric helps businesses understand how efficiently they manage their inventory, receivables, and payables to optimize liquidity and operational efficiency. If DPO is extremely short but DIO and DSO are extremely long, the business will need a good chunk of cash to survive. By closely monitoring and optimizing the CCC, businesses can identify potential issues and implement practical solutions to maintain efficiency and ensure a healthy liquidity position. As a result of implementing these solutions and understanding their potential impact, the company will have clarity and confidence in its ability to stay in business long enough for the cycle to complete.

Examples of CCC Optimization

Inventory Management (DIO): To shorten DIO, adopt a just-in-time inventory approach. If supplies to produce inventory are generally accessible and the manufacturing process is fairly short (think Etsy), a just-in-time approach may be appropriate. However, if supplies have a long lead time and the manufacturing process is lengthy, the market may not be willing to accept the long time between an order and its fulfillment.

Receivables Collection (DSO): The goal is accelerating cash collection on sales. One great example of an industry that has adopted highly accelerated cash collection is the airline industry. Customers are typically paying for travel arrangements a month or more in advance. Unfortunately, most businesses can’t adopt this model. One strategy that is more generally available is offering a discount for early payment. Conceptually, this is the same approach taken when accepting credit card payments. The business is willing to pay a fee (accept less cash) to receive the cash within 1-2 days.

Payables Management (DPO): Paying suppliers as late as possible without incurring penalties or damaging relationships is a key move to improve your cash position. Negotiate with suppliers to achieve longer payment terms. Understanding the priorities and constraints of suppliers can help the negotiation process. Perhaps they would be willing to offer more favorable payment terms if a priority is longer-term contracts.

Don’t Tackle It Alone

By prioritizing CCC optimization, businesses can develop resilience against unforeseen challenges, securing their financial health and operational stability. When you’re ready to gain clarity on your cash conversion cycle, contact us and we’ll be happy to start the conversation.