What is the Conversion Cycle?

Conversion cycle is also known as cash cycle or net operating cycle. Conversion cycle refers to how much time a company takes to turn its investments which is done from stock or any other financial resources into cash flows from sales.

What is the Conversion Period?

The period of time during which a convertible security can be exchanged for common stock is called a conversion period. The length of the conversion periods depends upon the kind of security. For example, some securities have expiration date while some last until maturity.

Conversion period calculation: The formula for calculating conversion period for inventory is

Inventory/cost of sales*365 days or

Inventory/daily sales

To find the average inventory for the year –

Inventory for the year = opening inventory + closing inventory/2

Cost of goods sold includes direct expenses such as labour, material and packaging.

Example:opening inventory for the year is $20,000 and closing inventory is $10,000.

Average inventory= opening inventory + closing inventory/2

                               = $20,000+$10,000/2

                                =$30,000/2

                                =$15,000

If the cost of sale is $80,000 then conversion period = 15,000/80,000*365 days

                                                                                    =68.4375 days

So, the conversion period for the inventory is 68.4375 days.

Element Involved in Cash Conversion Cycle

Following elements are involved in cash conversion cycle:

1) Days inventory outstanding (DIO): Days inventory outstanding is the average time taken to convert an inventory into finished goods and sell them.Days of Inventory Outstanding (DIO) is similar to DSO but instead of comparing Sales per day relative to average Receivables it looks at Cost of Goods Sold per day relative to average Inventory levels.

The formula for Days inventory outstanding = average inventory/cost of goods sold * 365 days. Where,

Inventory for the year = opening inventory + closing inventory/2

Cost of goods sold = opening inventory + purchases – closing inventory.

2) Days Sales Outstanding (DSO): Days Sales Outstanding (DSO) is the average amount of time in days that accounts receivable are waiting to be collected.Days Sales Outstanding or DSO can be described as average Accounts Receivable divided by Revenue per day.

Whenever ratios are used that mix Balance Sheet numbers (Accounts Receivable) with Income Statement numbers (Revenue) one should average the Balance Sheet numbers from the beginning and end of the period. This is because the Income Statement measures activity that takes place over the entire period, whereas a Balance Sheet is the valuation of the various accounts on a particular day (usually the end of the period).

DSO = (Accounts Receivable ÷ Net Credit Sales) x 365

Accounts receivable here is Receivables at the beginning of the period plus Accounts Receivable at the end of the period divided by two.

(Beginning Receivables + Ending Receivables) ÷ 2

3) Days Payable Outstanding: The Days Payable Outstanding (DPO) is the average length of time takes a company to purchase from its suppliers on accounts payable and pay for them.It measures the number of days of Accounts Payable the company has outstanding relative to their purchases of inventory or COGS.

The company, for instance, wouldn’t want to take so long to pay that it missed out on big discounts for paying early or incentives offered if there are any.

DPO = Ending Accounts Payable ÷ (Cost of Goods Sold ÷ 365)

Accounts payable in this element is:

(Beginning Payable + Ending Payable) ÷ 2.

Calculating the Cash Conversion Cycle

Operating Cycle

The first two components of the CCC, DSO namely DIO are what is called the Operating Cycle. This is how many days it takes for a company to process raw material and/or inventory and collect cash from the sale.

Operating cycle prefers the days which are required to receive the inventory, sell it and collect revenue from the sale of inventory. Operating cycle is very important to determine the efficiency of a business. A short operating cycle indicates more efficiency as it shows that the firm is able to recover its inventory, investment shortly and earn revenue.

Operating Cycle = DSO + DIO

Basically, the Operating Cycle tells how many days it takes for something to go from first being in inventory to receiving the cash after the sale.

Net operating cycle: determines the net, days of inventory outstanding and receivables in average. The formula for net operating cycle is

Net operating cycle = Inventory period + accounts receivable period – accounts payable period.

Using the Cash Conversion Cycle

Once all three of the required elements are calculated of the formula, one can calculate the CCC.

The Cash Conversion Cycle (CCC) is good information, but really only useful in calculating it every year and comparing it along with the three elements of the formula to business’s past performance.

The cash conversion cycle (CCC) is a metric that expresses the length of time (in days) that it takes for a company to convert its investments in inventory and other resources into cash flows from sales.

This metric takes into account the time needed to sell its inventory, the time required to collect receivables, and the time the company is allowed to pay its bills without incurring any penalties.

CCC will differ by industry sector based on the nature of business operations. It helps in boosting sales of inventory for profit is the primary way for a business to make more earnings.

CCC traces the life cycle of cash used for business activity. It follows the cash as it's first converted into inventory and accounts payable, then into expenses for product or service development, through to sales and accounts receivable, and then back into cash in hand.

Cash Conversion Cycle (CCC) = DIO + DSO – DPO

Example:

Calculate and analyze the cash conversion cycle for Hewlett-Packard (NYSE: HPQ) and Apple, Inc. (NYSE: AAPL) based on the information given below

Solution:

Cash conversion cycle for HPQ for 2012 = 52.51 + 27.27 – 55.51 = 24.27

The following table shows the cash conversion cycle for both companies for the three years.

AAPL has a negative cash conversion cycle of 44 to 52 days during the three-year period which suggests exceptionally good working capital management. It means that AAPL could sell and receive cash from its sales even 44 to 52 days before it actually made payments against its production inputs, which is impressive.

HPQ on the other hand drastically improved its cash conversion over the three years i.e. from 24.27 in 2012 to 11.09 in 2014, which suggests significant improvement in efficiency of the company. Still HPQ’s working capital management is not as good as AAPL. AAPL has been able to leverage its very strong market position to receive generous credit terms from suppliers.

Context and Applications  

This topic is significant in the professional exams for both undergraduate and graduate courses, especially for:

• B.B.A.
• M.B.A.
• Bachelor of Commerce