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    Mastering Working Capital - Controlling the Cash Conversion Cycle

    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.

    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.

    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’ cash conversion cycle, three critical questions need to be addressed:

    1. How much inventory do we need?
    2. Do we sell on credit? If so, on what terms and to whom do we offer it?
    3. 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 of Inventory Outstanding (DIO)

    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 for DIO is:

    DOI = (Average Inventory / Cost of Goods Sold) * 365 days = (1 / inventory turnover) * 365 days
    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: 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 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 stabilize 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, Periodic Order Quantity, or Least Unit Cost approach—can optimize your inventory management and help you achieve the best DIO for your business.

    Example of EOQ:

    Here a simple tool will be available to play around with numbers and determine the ideal EOQ

    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[1].

    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.

    DSO = (Accounts Receivable / Total Credit Sales) * 365 days
    With :

    • Account Receivables: the amount of money owed to your company from sales that have already been made.

    Receivables are typically split into two categories:

    • Trade credit - credit to other companies.
    • Customer credit - credit to customers.

    Watch out for hidden DSOs! 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?

    CFOrent-tip: to be inserted

    [1] Ross, Fundamentals of Corporate Finance, 10th edition

    Days of Payables Outstanding (DPO)

    Days of Payables Outstanding is the last of the three components. The ratio depicts how much of the working capital is needed to pay for the business' core activities.

    DPO = (Accounts Payables / Cost of goods sold (COGS)) * 365 days
    with:
    COGS: Begin Inventory + Purchases - End Inventory

    CFOrent-tip compare suppliers or negotiate better?

    Comparing with competition

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