Understanding the E-Commerce Cash Conversion Cycle
If you are an e-commerce business, it is important for you to learn about Cash Conversion Cycle because:
- It helps you manage working capital efficiently
- Fund your day-to-day operations
- Optimize cash conversion cycle to meet working capital needs
Efficiency in managing working capital is critical for an e-commerce business. As an e-commerce business, you need working capital to fund your day-to-day operations. It is because it takes time for inventory and investment in other inputs to get converted into sales and generate cash. That’s why it is important to track the Cash Conversion Cycle (CCC) metric. This is is because it helps you to know the time period your business needs to complete the process of creating goods or services using available resources to generate sales and get cash.
Thus, where CCC is the time period needed to complete the process of converting inventory into sales using given resources and generating cash. Working capital, on the other hand, is the sum of money required to support the e-commerce business during the CCC in which the cash is to in the process.
Accordingly, CCC is an important metric that must be tracked and regulated. This is because it helps you to evaluate the operational efficiency of your e-commerce business as well as your management’s decision-making capabilities.
A longer CCC is an indicator that a good part of your cash is tied up in business operations. That is, you may be holding onto unsold inventory, taking time to collect bills receivable, or paying your suppliers early leaving you with lower free cash flows. That’s why a shorter CCC is preferred as it indicates inventory getting sold quickly, efficient cash collection from debtors, and extended payables.
The reason why an e-commerce giant like Amazon is such a huge success is that it maintained a negative CCC. A negative CCC translates to an efficient cash collection policy and receiving cash from customers immediately. We’ll have a look at how minimizing CCC is a reflection of efficient business operations and an important metric for evaluating your company’s liquidity position.
In this article, we will discuss what is Cash Conversion Cycle, Cash Conversion Cycle Formula, and a cash conversion cycle example showing why minimizing CCC is important.
What Does Cash Conversion Cycle Mean?
Cash Conversion Cycle (CCC) is the time period required to convert investment in inventory and other inputs into sales to generate cash. CCC is also called cash cycle, cash to cash cycle, or cash operating cycle. It is a cycle that involves purchasing inventory, using resources like working capital and other inputs to produce goods and services, and time is taken to sell them and collecting payments from customers.
Therefore, regulating CCC is important for an e-commerce business. This is because it reflects the efficiency of your business operations. In other words, CCC showcases how effective are your inventory management, credit collection policy, and supplier management. That is, how quickly your inventory gets converted into sales, the time it takes to receive payments from your customers, and for how long can you delay payments to your suppliers.
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Thus, CCC reveals the efficiency of your e-commerce operations and managerial decision-making. Accordingly, an e-commerce company’s CCC showing stable or decreasing figures over time is a good indicator. However, the increasing CCC reveals that one needs to analyze more about a company by considering other aspects.
Let’s have a look at the cash conversion cycle formula to understand the cash conversion cycle in detail.
How do you Calculate Cash Conversion Cycle?
As stated earlier, CCC is the time period it takes for your inventory and other resources to get converted into sales and generate cash. Accordingly, the cash conversion cycle formula is expressed in a number of days and has the following three components.
What are the 3 Components of the Cash Conversion Cycle?
The cash conversion calculation involves three components. The cash conversion cycle formula is as follows.
Cash Conversion Cycle (CCC) = DIO + DSO – DPO
DIO = Days Inventory Outstanding
DSO = Days Sales Outstanding
DPO = Days Payables Outstanding
The CCC of a company moves through three different stages. Thus, for cash conversion cycle calculation, you need to keep handy certain items from the company’s financial statements.
- Beginning and closing inventory for the period
- Cost of goods sold (COGS) from the company’s income statement
- Opening and closing accounts receivables for the period
- Opening and closing accounts payables for the period
- Number of days that comprise the period (that is annual (365 days) or quarterly (90 days) statements)
Let’s have a look at each of the three components in detail.
1. Days Inventory Outstanding (DIO)
DIO is the first stage that takes into account the current inventory levels. This stage reveals the time it takes for your business to sell the existing inventory. That is why a low DIO is preferred and companies strive to minimize it by selling their inventory on hand quickly.
Thus, the time period a company takes to clear out its inventory reveals some critical insights about the company’s inventory management policy.
- For instance, a high DIO may be a sign of inefficient inventory management. Whereas, a low DIO means that the company is able to sell its inventory quickly and generate cash flow. This cash flow is further may be used in meeting its short-term payment obligations.
- Further, more number of days to convert inventory into sales could also mean insufficient demand for the product, a wrong target market, or unreasonable product pricing. On the other hand, a low DIO generally indicates that the company is efficient in managing its inventory. That is, it takes less time in selling its inventory, generating free cash flows to meet its short-term debt obligations.
- Similarly, slow-moving inventory may also indicate inventory becoming obsolete. This would mean that company needs to roll out huge discounts or strategies like product bundling to sell off inventory quickly. On the other hand, inventory moving out quickly would generate cash flows for the company. However, there can be cases where companies with a reduced DIO may have inventory levels reaching zero. And this would mean losing out the business opportunity to the competition.
Now, the inventory in the company’s balance sheet reveals the dollar value of raw materials, work-in-progress, and finished goods. There are two ways to calculate DIO which are as follows.
1. DIO Using Average Inventory and COGS
This method involves average inventory and COGS to calculate DIO.
Average Inventory is the mean of inventory values of two more given periods. Accordingly,
Average Inventory = (opening inventory + closing inventory)/2.
Whereas, Cost of Goods Sold (COGS) is the direct cost of acquiring producing goods and services that a company sells during a given period. Thus, it includes only the cost of material, labor, and overheads that are directly associated with the production of goods or services.
Cost of Goods Sold (COGS) = opening inventory + purchases (during the period) – closing inventory.
Thus, DIO = (Average Inventory /COGS) X 365 days
2. DIO Using Inventory Turnover
Inventory turnover is the ratio that indicates the number of times a company has sold and replaced its inventory in a given time period. This ratio is an important indicator of how efficiently a company is managing its inventory.
Accordingly, a high inventory turnover ratio indicates that the company’s goods or services have a robust demand in the market. Similarly, a low inventory turnover ratio reveals that there exists a long time gap between acquiring raw materials, producing, and selling goods to customers.
DIO = 365 days/Inventory Turnover
2. Days Sales Outstanding (DSO)
Days Sales Outstanding (DSO) is metric that measures the average number of days it takes a company to collect payments for the sales made during a given period. DSO may be calculated on a monthly, quarterly, or annual basis.
DSO is also called average collection period or days receivables. Accordingly, a lower DSO is preferred so that the cash received can be put into the business operations.
Thus, DSO indicates that the company is able to collect payments from customers quickly and has an efficient collection policy. On the other hand, a high DSO indicates that there are delays in payment collection from customers.
DSO = (Accounts Receivable/Total Credit Sales) x Number of Days
3. Days Payables Outstanding (DPO)
Days Payables Outstanding is a metric that measures the average number of days a company takes to pay its short-term obligations. These may include suppliers or financiers. This, too, is an important metric as it reveals the efficiency of a company’s payment policy.
Accordingly, a higher DPO is preferred as it makes the funds available with a company for a long time which it can use to its benefit. However, a consistently high DPO may also hint that the company is not able to pay off its bills outstanding within time. And this may result in straining its relationship with its suppliers who may not be willing to supply raw materials to the company on credit.
Likewise, suppliers may give you goods on credit on terms that may not be to your company’s benefit. Similarly, you may not be able to avail of discounts due to delay in making payments and may end up paying higher for the inputs.
Thus, when a company purchases raw materials and other inputs on credit, it results in bills payable. Bills payable reveal the short-term obligation that a company must pay off to its outstanding suppliers.
Now, the time between receiving bills and the cash actually going out towards payments of these outstanding suppliers is extremely important.
DPO = (Accounts Payables/COGS) x Number of Days
This formula considers the average per day cost for producing goods that are to be sold by the company. Therefore, the DPO gives us the number of days in which the company is able to pay its short-term obligations after it receives its bills.
Cash Conversion Cycle Diagram
Negative Cash Conversion Cycle Example
Typically, it is preferred to minimize the cash conversion cycle as it implies that companies require less time to convert working capital into cash. However, a lower CCC still means that the company’s cash is tied up in business operations for some time.
Although it happens in a few cases, certain companies’ cash conversion cycles can be negative. Cash conversion cycle negative value means that instead of cash being tied up in the business operations, you actually have excess cash.
This is achieved by receiving upfront cash payments from customers and inventory being sold quickly or frequently.
The best example we can take for understanding how the cash conversion cycle can be negative is that of the e-commerce giant Amazon. As per the Amazon annual reports, the e-commerce giant is able to turn its inventory quickly and thus has a cash-generating operating cycle or a negative cash conversion cycle.
Since Amazon sells its products majorly to the retail market, it gets paid upfront for its sales with consumers using debit or credit cards for payments. And it receives payments from its customers before it is required to pay its outstanding suppliers.
Thus, by having a negative cash conversion cycle, Amazon is able to fund its business operations by reaching appropriate delayed payment terms with the suppliers.
The following is the chart that displays the cash conversion cycle of Amazon over the period from 2001 to 2021.
As you can see, the CCC of Amazon for Q4 2021 is -28.24 days. This is calculated by using the CCC formula = DIO + DSO – DPO
Where, the component figures are as follows:
DIO for Q4 2021 = 36.58
DSO for Q4 2021 = 21.84
DPO for Q4 2021 = 86.66
Accordingly, CCC = 36.58 +21.84 – 86.66 = – 28.24 days
Thus, by managing its inventory properly and receiving prompt payments from customers, Amazon is able to keep its days receivables and day inventory very low.
This translates to Amazon receiving payments for products it sells before it is required to pay its creditors. This is what has enabled Amazon to use the surplus cash into the business for its growth.
Thus, with its business growth over the years, Amazon’s free cash flows from a negative cash conversion cycle also increased. This placed them in a position where they could demand good credit terms from their suppliers.
This gave Amazon more time to pay its outstanding suppliers, helping them grow phenomenally.
Cash Conversion Cycle Interpretation: What Does CCC Tell You?
Many companies miss on tracking the cash conversion cycle which is a critical metric to evaluate the cash flow of a business. As seen in the Amazon example above, measuring CCC can provide some extremely valuable insights. For instance, one can know whether the company has efficient inventory management, payment collection, and extended payables. Similarly, one can know
Thus, CCC measures the company’s managerial efficiency. It reveals how quickly the company is able to convert its working capital into cash on hand. This increased cash on hand is generated by first investing existing cash or working capital into purchasing inventory. This results in accounts payables. Next, the inventory is then converted into finished goods and sold, resulting in accounts receivables. Thus, CCC traces the time it takes for a company to convert cash tied up in inventory and other inputs into cash-in-hand.
Finally, the money collected against accounts receivables results in cash generation which is again invested in the business.
So, What is a Good Cash Conversion Cycle?
The typical question that is asked in respect of CCC is what is better – cash conversion cycle high or low. A shorter or lower CCC is preferred as it means less time gap between purchasing inventory and selling goods and receiving cash for a company. Lesser the time period in this case, the better it is for the company as it will have free cash flows to invest in the business for generating increased sales.
A shorter CCC would mean cash flows being easily available with a company which it can use to buy more inventory and generate more sales and profits. The frequent availability of working capital will allow a company to produce and sell more.
Further, it can make credit purchases easily, extend credit to customers by selling goods on credit, and even demand better credit terms from its vendors. But it all depends on how quickly it is able to convert inventory and other inputs into sales and generate cash. And this is what CCC reveals. It tells how quickly a company can convert cash invested in inventory and other inputs into accounts receivables and cash.
Thus, inventory management, payment collection, and bills payables are the critical aspects of CCC. Any issue with even one of these can translate to a business having insufficient cash flows.
These issues could be:
- Inefficient inventory management like inventory pile-up
- Challenges in generating sales
- Paying vendors quickly or inability to pay them a
Thus, CCC also reveals the efficiency with which the company’s management is
Is Higher Cash Conversion Cycle Better?
A higher or lengthy cash conversion cycle is not good as it means the company takes a longer time to convert investment in inventory and other inputs into cash. Many smaller companies having lengthy or a higher CCC actually go insolvent. This is because they do not have enough cash to run day-to-day business operations. Lengthy CCC would mean that companies are either piling on inventory, are taking time in collecting payments from customers, or paying their vendors way too early.
On the other hand, shorter CCC would mean inventory moving quickly, payment collection taking less time, and delayed payments to vendors. This puts the company in a healthy position as it is able to meet its short-term payment obligations.
What is Cash Conversion Ratio or Cash Conversion Rate?
Cash conversion ratio (CCR) or cash conversion rate is a term that seems similar to CCC. But both are very different from each other. Cash Conversion Ratio is a ratio that measures the amount of cash flows a company generates against its accounting profit. These cash flows represent cash flows from operations and account profit is net profit after interest, taxes, and amortization.
Thus, the cash conversion ratio is a tool that helps in determining the liquidity position of the company. It is calculated by dividing cash flows divided by net profit. Accordingly, a higher CCR indicates that the company has a good liquidity position.
Whereas, CCC indicates how quickly a company is able to convert its investment in inventory and other inputs into cash.