How to optimise your cash conversion cycle (CCC) for growth

As an SMB owner, optimising cash flow is at the very top of your list of priorities. To do this, you need a close eye on how money flows in and out of your business, and the key levers influencing these flows. 

That’s your cash conversion cycle in a nutshell, and this article explores how to take control of yours.

First, we’ll explain how to calculate it. You'll understand why this indicator and its components (DSO, DPO and DIO) are levers for managing your company's commercial activity on a day-to-day basis, and how they help anticipate a growth phase.

1 - What is the cash conversion cycle (CCC)?

Your cash conversion cycle is the amount of time (in days) it takes to turn your inventory (and the money you’ve spent on it) into sales receipts. This is the delay between your investments and the relevant cash actually arriving in your accounts in return. 

This is sometimes also known as the operating cycle, and is similar to the definition of working capital requirement (WCR), another ratio you need to be aware of in terms of cash management.

1.1 - How the cash conversion cycle works

We think of cash conversion as a cycle because it involves several related steps:

• Purchases create debts with suppliers, which are eventually paid off (outgoing cash).
• Products or services in progress are held in stock until the day they are sold, at which point the stock disappears.
• Sales invoices are issued to customers and settled by collections (incoming cash).
• You make new purchases or investments, and the cycle continues.

The “lead time” between the beginning and end of the cycle is a key indicator of company efficiency. The longer the conversion period, the slower the money arrives in the bank account and the less cash you have on hand.

1.2 - DIO, DSO, DPO: The cash conversion cycle formula

The business cycle described above can be measured using the CCC, which is the number of days required to convert purchasing flows into bank cash. Here is the formula for calculating the cash conversion cycle: CCC = DIO + DSO - DPO.

The components of the CCC calculation are :

• Days Inventory Outstanding (DIO): the average number of days inventory remains in your stockpile.
• Days Sales Outstanding (DSO): the average payment period for trade receivables, measured in days. (How long it takes your customers to pay.)
• Days Payable Outstanding (DPO), the average time taken to pay supplier debts.

Because each of these factors is expressed in days, your resulting CCC is too.

1.3 - Why use CCC to assess operations?

Each component in the CCC formula has an impact on the final result. The DPO, DSO and DIO all contribute to the average number of days needed to convert your purchases into cash in the bank.

So monitoring this financial indicator helps you manage your SMB's cash flow. Any significant increase should catch your attention. (A lower number means a shorter delay in recouping your costs, which is almost always a good thing.) 

This information, calculated period by period, also makes it easier to plan ahead. It's essential to keep an eye on your cash runway, so you don't end up in the red.

2 - Analysis of the three components of the cash conversion cycle

Let’s use a practical example. You can also practise using the accounts for your last financial year.

2.1 - Average time taken to pay supplier invoices (DPO)

The operating cycle begins with purchases. A company shows the following amounts in its accounts:

• Trade payables on the liabilities side of the balance sheet: 360
• Purchases and external charges on the income statement, excluding VAT: 4,000
• VAT rate on purchases 20%
• Purchases and external charges including VAT of 4,000 x 1.20 = 4,800
• Calculation of DPO or Days Payable Outstanding: (360/4,800) x 360 days = 27 days

In this company, on average, supplier invoices are paid after 27 days. The higher the ratio, the more the company keeps its cash in-house. 

But a DPO that’s too high can also be a risk. It may be a sign that the company can no longer afford to honour its debts. And by stretching supplier lead times, companies are putting their supplies at risk, particularly if the supplier stops deliveries as a result.

2.2 - Average time to transform company inventories into sales (DIO)

The second stage in the operating cycle revolves around inventory. Here are the data for this same company to calculate the time taken to turn inventories into sales (or DIO):

• Stock of goods on the assets side of the balance sheet: 500
• Purchases of goods over the year according to the profit and loss account: 3,000
• DIO = (500/3,000) x 360 days = 60 days.

In this case, the company has two months' inventory on hand. On average stock is rotated every two months, although this may involve variable lead times within the stock, depending on the items to be sold.

By monitoring how this ratio evolves, you can quickly spot any deterioration or improvement. Managing the entire supply chain, and optimising supplies in particular, is of vital importance here. If you have a tendency to overstock, your DIO will rise and your cash flow will suffer. (Not to mention storage costs, which also have a financial impact.)

Conversely, aiming for a very low DIO carries the risk of running out of stock. This is detrimental from a sales point of view, especially if you want to build customer loyalty.

2.3 - Average time to receive payments (DSO)

Finally, the operating cycle ends with sales and payments received from customers. This third item in the cash conversion cycle is calculated as follows:

• Trade receivables on the assets side of the balance sheet: 480
• Sales excluding VAT for the year: 4,500
• VAT rate on sales: 20%
• Sales including VAT for the year = 4,500 x 1.20 = 5,400
• DSO or Days Sales Outstanding = (480/5,400) x 360 days = 32 days

This company takes an average of 32 days to collect receivables from customers. Although the average payment terms on invoices are 30 days, this DSO shows that the agreed payment dates are being met fairly well. 

In general, you need effective dunning (collections) procedures, and the absence of slippage for certain customers. The lower the DSO, the faster the conversion and the better your cash position.

2.4 - Calculating of the cash conversion cycle (CCC)

Still using our trading example, the CCC at the end of the financial year is: DIO + DSO - DPO = 60 days + 32 days - 27 days = 65 days. 

The company therefore takes just over two months to convert its purchases into cash.

3 - Challenges and levers to optimise your CCC

Keeping an eye on your cash flow should be quick and easy. But this is one of the first challenges. Most small businesses don’t have an easy grasp on cash, and therefore can’t optimise this cycle. 

Here are some key considerations. 

3.1 - Monitor your company's working capital requirement

In the majority of companies, operations do not generate surplus cash. You’re always waiting for payments to come in to make yourself whole. So you need to find cash elsewhere to function properly. 

The flipside of this is a negative working capital requirement — basically the Holy Grail of growth. But most companies don’t have such luck.

So the first thing to do is to monitor your CCC at the end of each month. And if possible, automate the calculation of DIO, DSO and DPO, based on the monthly account balance.

Important: if you make the calculation during the year, adjust the ratios to take account of the actual number of days elapsed, instead of 360 days.

3.2 - Track changes in the components of the cash conversion cycle

As with the management of WCR, it’s important to watch how the CCC evolves over time. Even though this ratio is calculated in days, any increase in it should give you early warning. 

A simple, periodical dashboard should show the number of days in the cash conversion cycle. You can then analyse each of the three flows and try to understand why one of the ratios is deteriorating, for example, or perhaps even improving.

3.3 - Anticipate cash requirements for seasonal fluctuations or sales growth

Some companies have cycles with sales peaks. This is the case for seasonal businesses or one-off campaigns. In these cases, the amount of purchases and stocks fluctuates in preparation for the sales period.

You must anticipate these and identify ways of financing these seasonal peaks in working capital requirements.

Organisations planning to grow their business, and therefore their sales, face the same problem. As sales increase, so do working capital needs. So if the CCC in our example is 65 days of activity, with an increasing level of sales, 65 days requires more money. 

This type of strategy requires you to anticipate and manage your cash conversion cycle, and even to finance it by taking out a working capital loan.

3.4 - Influence each of the components of the CCC

One of the ways of rapidly improving your company's liquidity ratio is to act on one or more of the components of the cash conversion cycle. Once you have measured the CCC, you can begin a methodical analysis of each component. Then decide on an action plan. 

Start internally. Your own business organisation can often be improved. It sometimes offers unsuspected resources for improving management.

Review the following possible actions within the company:

• Reduce stock levels by optimising the supply chain, logistics, inventory, storage, etc.
• Reduce trade receivables by improving collection, invoicing more quickly after delivery, reducing the time granted to customers and introducing trade discounts.
• Extend the average supplier payment period, without jeopardising your supplier relationships.

3.5 - Solve your cash conversion cycle problems with a short-term credit line

Are the company's internal levers not enough to solve your cash flow problems? There are other ways of optimising the cash conversion cycle, including short-term financing for one of the items in your operating cycle.

Rather than waiting months to expand, deploy growth strategies by turning this short-term financing into real operating levers. 

Some of the ways of doing this outside the company include:

• Financing accounts receivable with factoring or similar solutions
• Inventory financing, a way of paying supplier invoices even if you don't have the cash on hand at the time.

A short cash conversion cycle means efficient operations

Hopefully it’s clear just how important your CCC is for company cash flow. It's vital to start by measuring it. 

Then you can move on to analysis and optimisation, and perhaps look for working capital financing solutions where appropriate. 

If you’re at that stage, see how easy and effective Defacto’s working capital loans are. They take just seconds to apply for, and can help you on both the DSO and DPO sides of the equation. Perfect to keep that cash flowing.