The Cash Conversion Cycle
You may have heard a measure called "number of days of receivables" before. Does this sound similar to DSO?
Actually, it is.
You're right! It is.
It's exactly the same thing. DSO is how many days on average that a sale stays as a receivable.
So logically, how would you put DOH and DSO together as you're calculating your cash conversion cycle?
Of course.
No, you'd need to add them.
It takes time to sell some stuff, and then it takes time to collect on the sale. So DOH + DSO gets you pretty close to your cash conversion cycle (and is typically the definition for the operating cycle).
In fact, if you took the cash collected and bought new inventory, you would be right back where you started with inventory ready to sell. How would you need to purchase that new inventory if you wanted cash to be complete in its cycle as well?
Right!
You needed some time to sell, and some time to collect. Use that cash to buy new inventory today, and the cash conversion cycle is complete.
No, in cash. Think about it: you needed some time to sell, and some time to collect. Use that cash to buy new inventory today, and the cash conversion cycle is complete.
But if you purchased your inventory on credit, you wouldn't even need to wait for all of the customers' cash. What does that suggest for how buying inventory on credit and maintaining accounts payable should affect the cash conversion cycle?
Nope. Shorter. Here's why:
Of course!
With inventory purchases on credit, you can buy inventory a couple weeks before even collecting cash from sales. That means you get back to that starting position even faster, making it a shorter time that the cash conversion cycle (recall, also called the operating cycle) is complete. This length of time is the __days payable outstanding (DPO)__.
So the cash conversion cycle is DOH + DSO - DPO. If your suppliers were really patient with you as far as ordering on credit, how low could your cash conversion cycle go?
The __cash conversion cycle__ is a measure of the operating efficiency and working capital management of a company. It's a sort of extension of the operating cycle of the company, which is the process of getting inventory, selling it, and collecting cash. For most businesses, this cycle happens many times per year. And the shorter, the better.
Now you've made some sales on credit. You want to get the cash. What part of the financial statements will you be looking at the most here?
No, that piece of inventory just went out the door. Now the focus is on collecting the cash.
No, that's related to the stuff that you buy, not what you sell.
Absolutely.
Accounts receivable is an asset account, which is nice, but it also represents not getting paid yet. So the __days of sales outstanding (DSO)__ is another big part of the picture: how long sales stay "outstanding" in accounts receivable.
Start with you and your little business somewhere. You have inventory, everything is set up, and you're ready to sell. How would the length of time you hold inventory relate to your cash conversion cycle?
No, it would. There's a clear relationship to identify here.
That's not right.
Holding inventory for a long time wouldn't help you get cash back more quickly.
Absolutely!
If you want cash, you need to make some sales fast. Faster sales means less time that inventory is in the back room. So the __days of inventory on hand (DOH)__ is one big factor in determining the cash conversion cycle.
No, it would probably not be exactly zero. You could do even better.
Sure!
Imagine that you ordered inventory today and got the stuff onto your store shelves. You owe your supplier in 30 days, and you plan to pay exactly then. Your DOH averages 12 days, and then it takes 13 days on average to collect on your sales. All of the cash from sales is on your account before you even need to pay for what you sold.
No, it wouldn't have to be positive. You can go lower.
What is the cash conversion cycle in this case?
That's right!
Actually, it's -5. Recall the cash conversion cycle calculation and how these numbers would go together for this example:
$$DOH + DSO - DPO$$
$$ = 12 + 13 - 30 = -5$$
That's some very efficient use of cash if you can keep it up!
To summarize:
[[summary]]
No
Yes
Subtract them
Add them
On credit
In cash
Longer cash conversion cycle
Shorter cash conversion cycle
Continue
Inventory
Accounts payable
Accounts receivable
It wouldn't
Less time holding inventory, longer cash conversion cycle
Less time holding inventory, shorter cash conversion cycle
Zero
Something negative
Something small but positive
Other responses
-5
Continue
