As the saying goes: “Cash is king!”. But do you know where your cash is? Welcome to the second part of our three-part series on mastering your working capital.
Controlling the Cash Conversion Cycle
Today, we’re diving into the Cash Conversion Cycle (CCC)— a dynamic metric that encompasses three key components: Days of Inventory Outstanding, Days of Sales Outstanding, and Days of Payables Outstanding. In our previous blog, we explored Net Working Capital as both an absolute number (current assets minus current liabilities) and as key ratios like the Current and Quick ratios.
The CCC, part of asset management ratios, is typically expressed in days. It helps illustrate where your working capital is invested and how long, on average, each dollar stays tied up in your business before it’s converted into cash—and hopefully profit. The longer this cycle takes, the more capital is tied up in your operations.
The formula is straightforward:
CCC = DIO + DSO – DPO
where:
- DIO = Days of Inventory Outstanding
- DSO = Days of Sales Outstanding
- DPO = Days of Payables Outstanding
These components—Days of Inventory Outstanding (DIO), Days of Sales Outstanding (DSO), and Days of Payables Outstanding (DPO)—are known as activity ratios. The CCC measures the time difference between when your business pays for inventory (DPO) and when it collects cash from sales (DSO), on average. They can be measured over any given period of days, e.g. 30, 90 or 365 days, as long as all components relate to the same period.
Let’s be clear: the CCC is most relevant when your business has all three components. If your company doesn’t have significant inventory, the CCC may not be as useful for managing your working capital. To fully understand your business’s cash conversion cycle, three critical questions need to be addressed:
- How much inventory do we need?
- Do we sell on credit? If so, on what terms and to whom do we offer it?
- How do we finance our short-term payables?
Answering these questions will introduce a variety of variables that must be factored in when calculating the Cash Conversion Cycle.
Other cycles in the Mix
Though we won’t delve deeply into them here, it’s worth mentioning that there are several variations of the cash conversion cycle:
- Weighted CCC: This approach weighs the amount of funds invested at each stage of the cycle.
- Net Trade Cycle: A version where all three components (DIO, DSO, and DPO) are related to sales.
- Operation Cycle: Focuses on the asset side, excluding payables.
Days Sales Outstanding
It’s a well-known fact that allowing goods to be sold on credit can boost sales. While this practice isn’t typically used for small consumer goods in B2C, a large proportion of B2B sales are made on credit. In fact, approximately one-sixth of all assets in U.S. industrial firms are tied up in accounts receivable, according to Fundamentals of Corporate Finance, 10th E. by Stephen A. Ross.
DSO represents how much of your working capital is tied up in credit sales. It shows the proportion of assets that are yet to be collected as cash from customers.
Its formula:
With:
- Account Receivables: The amount of money owed to your company from sales that have already been made.
- Cost of Goods Sold: The direct costs of producing the goods, representing the working capital investment required to maintain core business operations.
Receivables are typically split into two categories:
- Trade credit - credit to other companies.
- Customer credit - credit to customers.
Balancing your DSO
Giving out credit to your buyers can increase sales. On the other hand, your company has to be able to lend this money in the first place. You can only do this, with sufficient working capital. If your business finds itself in a production chain, demanding cash payments from your customers can be very difficult, so lending them credit might be necessary. How can your DSO be lowered then? Well, there are several options:
- Offer a discount to early payers, for example a 2/10n30 (2% in 10 days, else full in 30 days).
- Factor the accounts receivable. Sell the collected debt to a third-party for a discount.
- Negotiate a better trade credit (= raising DPO). Depending on the business, higher trade credit can be negotiated. The airplane manufacturer Boeing for example, has allegedly trade credit up to 263 days.
*CFOrent-tip *: Watch out for hidden DSOs!
CFOrent-associate Benjamin shares an example: " Take CoffeeBeans N.V., a supplier to Moonbucks, a well-known coffeehouse chain. CoffeeBeans N.V. delivers fresh beans every Monday, and the agreed payment terms are 30 days. However, Moonbucks uses an invoice management system that automatically approves invoices within 48 hours. The real payment period then becomes 30 + 2 days.
If Moonbucks changes its policy to only accept invoices between the 25th and the end of the month, a larger hidden DSO arises. For example, if CoffeeBeans N.V. delivers on April 5th but can’t send the invoice until the 25th, which then needs 48 hours for approval and another 30 days to be paid, the real DSO becomes 20 + 2 + 30 —a staggering 52 days. Not what they agreed upon, is it?"
Curious about best practices for keeping your CCC-components on-point? Stay tuned to our blogs as we will explore the three components in-depth in the future and talk about best practices to keep each component healthy!
Days of Inventory Outstanding
Days of Inventory Outstanding (DIO) has many synonyms, but they all point to the same concept: how quickly can a business convert its inventory into sales? This metric reflects how long a company's inventory typically lasts, from the moment it enters storage until it is sold and leaves the premises. While the ideal DIO varies across industries, a lower number is generally preferred, as high DIOs may signal inventory mismanagement or sales challenges.
The formula is:
With:
- Average Inventory: The total value of all materials—raw, processed, or finished—that are essential for maintaining the company's core activities and directly related to its turnover (and profit).
- Cost of Goods Sold (COGS): The direct costs of producing the goods, representing the working capital investment required to maintain core business operations.
Essentially, DIO is a ratio that compares the value of average inventory to the total cost of generating those goods. The result shows the portion of COGS represented by your inventory. By multiplying this figure by, for example 365 days, we express the result in a more intuitive format—how many days your inventory typically remains unsold.
While the formula suggests that a smaller average inventory is more beneficial, the reality is more complex. Larger inventories can help stabilise price fluctuations and reduce order costs, but they also increase carrying costs.
Depending on the characteristics of your inventory depletion, several models—like the Economic Order Quantity (EOQ), the Part-Period Algorithm, Just-In-Time, or Least Unit Cost approach—can optimise your inventory management and help you achieve the best DIO for your business.
Days Payables Outstanding
Days of Payables Outstanding is the last of the three components. The ratio depicts how many days you can defer payments. A high DPO means purchases, on average don't have to be paid immediately but rather after a certain amount of days.
Its formula:
With:
- Cost of Goods Sold: Begin inventory + purchases + end inventory.
DPO becomes interesting when we put it in perspective of other metrics, such as the DSO or the operating cycle.
DSO versus DPO
Comparing these two components will tell you whether your clients pay your business faster than you pay your suppliers. If they do not, your company will have to provide the financing of working capital itself and this can become a very expensive affair. In a company, we differentiate two ways of financing: equity or debt. Banks or similar institutions offer loans with interest. Euribor rates for one month are around 3.38%, add between 1 - 2.5% on top and covering your working capital by loan will cost you ± 5% of the required working capital. The other option is to ask the shareholders to invest a little more. Shareholders usually expect higher returns on invest because they carry more risk and your company might be looking at a much higher percentage on top of the working capital needs. Our upcoming article on WACC will explore this further.
* CFOrent-tip *: A high DPO can also send out a negative signal into the world, as they can be related to payment troubles. Professor Corporate Finance Marc Deloof of the University of Antwerp concluded in a study of around a thousand Belgian companies, that managers who lower the DSO and DIO can create value for shareholders and that less profitable firms, wait longer to pay their bills.
Troubles with a high DPO? Get in touch!
Operating Cycle
The operating cycle gives an estimation in days of your entire core business operation. It starts the days you receive your raw materials (or similar) in inventory and it ends when you have sold everything AND collected the money. The operating thus exists out of two other cycles: the DPO and the Cash Cycle.
Unveil the Opportunity Cost of Your CCC
Investing funds has a price. In the standard example of our calculator below, we notice a CCC of 138 days. In other words, for every euro we invest it will take on average 138 days to turn into revenue. However, the WACC sets expectations of what the return on our investment should be. Tying this one euro up in our business activities has a cost for our business. Play around in our calculator and find out how these parameters influence the opportunity cost for investing your working capital. Do you see what happens if you manage to get a negative CCC?
according to the formula:
Developed by
Trade Winds FV
Conclusion
Having discussed the components of the CCC, we've discovered its more actionable nature. Converting ratios into days, provides a more insightful way to understand where your working capital is being spend or stuck. Each component has several underlying assets or liabilities that need to be assessed in order to balance your working capital.
Working Capital Management always needs to be assessed within the nature of your business and compared with relevant companies/competitors. The Cash Conversion Cycle is no exception of this philosophy.
Coming up...
In our third and last part of our three-part series, we will talk about the Weighted Average Cost of Capital (WACC). In this article, we mentioned that shareholders may expect a high return on their investment and therefore are not always the most suitable moneylenders for our business. The WACC gives an indication of our debt, allows us to leverage debt-to-equity and provides a meaningful number to decide whether an investment will be worth it.
