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Cash Conversion Cycle

By Yuriy Smirnov Ph.D.

Definition

The cash conversion cycle measures the period of time in days from the moment inventories are paid until the moment accounts receivable is collected. In other words, it is the duration of working capital turnover. Therefore, the duration of the cash conversion cycle determines the working capital needs of a business. The longer it is, the greater the working capital needs and vice versa.

Formulas

The duration of the cash conversion cycle can be calculated as follows:

Cash Conversion Cycle = Operating Cycle - Days Payables Outstanding

Using a deeper decomposition of the operating cycle, the equation above can be transformed as follows:

Cash Conversion Cycle = Days of Sales in Inventory + Days of Sales Outstanding - Days Payables Outstanding

Formulas for days of sales in inventory (DSI), days of sales outstanding (DSO), and days payables outstanding (DPO) are as follows:

DSI =  Average Inventory  ×T
COGS
DSO =  Average Accounts Receivable  ×T
Credit Sales
DPO =  Average Accounts Payable  ×T
Cost of Sales

where COGS is the cost of goods sold, and T is the number of days in an accounting period.

Cost of Sales = Beginning Inventory + Purchases - Ending Inventory

Graph

The graph below shows the relationship between the operating cycle and the cash conversion cycle.

Relationship between the operating cycle and the cash conversion cycle

Negative cash conversion cycle

As was mentioned above, the shorter the cash conversion cycle of a business, the lower its need for working capital. It can also happen that its value turns negative. It means that the accounts payable period is greater than the duration of the operating cycle of a business. In such a case, the working capital needs of a business are financed by trade accounts receivable.

Calculation example

Information about inventory, accounts receivable, and accounts payable of Total SAR in the 20X8 financial year is as follows:

US$

The company also reported in 20X8 credit sales of $5,475,000, cost of goods sold of $3,285,000, and purchases of $2,920,000.

Let’s find the days of sales in inventory, days of sales outstanding, and days payables outstanding of Total SAR.

Average Inventory =  $580,000 + $500,000  = $540,000
2
Average Accounts Receivable =  $730,000 + $770,000  = $750,000
2
Average Accounts Payable =  $310,000+$330,000  = $320,000
2

Cost of Sales = $580,000 + $2,920,000 - $500,000 = $3,000,000

DSI =  $540,000  × 365 = 60 days
$3,285,000
DSO =  $750,000  × 365 = 50 days
$5,475,000
DPO =  $320,000  × 365 = 39 days
$3,000,000

Thus, the duration of the cash conversion cycle of Total SAR is 71 days (60+50-39).