Cash Conversion Cycle

How is it calculated?

Cash Conversion Cycle = Days Inventory Outstanding + Days Receivable Outstanding - Days Payable Outstanding

Goal of the Ratio

The Cash Conversion Cycle is a calculation that pulls together then Days Inventory Outstanding, Days Receivable Outstanding & Days Payable Outstanding into a single metric.  The goal of this metric is to determine how quickly a business can convert its initial investment into inventory back into cash.  This metric represents the minimum amount of capital necessary to fund the operations of the business.  This minimum capital requirement can be funded through a combination of cash and credit.  The Cash Conversion Cycle provides the basis to determine the financing gap present in a business.

When is it used?

This calculation can be used in any business where capital travels through the form of cash into inventory into accounts receivable and back into cash.

Rules of Thumb

Quicker is better, but not too quick for the industry.  The shorter this cash conversion cycle, the less capital required for the business.  This does not mean that a short cycle is ultimately ideal though because if credit terms are too short for the industry, a company may lose out on additional revenue because potential customers value the credit terms offered by competitors more than the value provided by the borrower.

Please note all ratios should be viewed in relation to industry norms to determine overall adequacy.

What changes in the ratio could mean:

Some example reasons why the Cash Conversion Cycle can change:

1. See potential changes of the Days Inventory Outstanding
2. See potential changes of the Days Receivable Outstanding
3. See potential changes of the Days Payable Outstanding

Other Relevant Terms

• Capital
• Balance Sheet
• Working Capital
• Return to Terminology Library