Cash Conversion Cycle

What is the cash conversion cycle?

Cash conversion cycle (CCC, German Geldumschlagsdauer) refers to the number of days between payment of suppliers and receipt of payment from the customer. During this time, a company pre-finances its operating business itself. It results from three periods: how long goods lie in stock, plus how long customers take to pay, minus how long the company can keep its suppliers waiting. If a retailer pays for its goods on 1 March and receives its customer's money only on 15 May, it finances these 75 days from its own funds.

The metric belongs to the management of working capital, that is, the capital tied up in inventories and customer receivables less supplier liabilities. It is used in controlling, in credit review and in financial due diligence. It can be derived from the annual financial statements, the monthly closing or the management accounts (Betriebswirtschaftliche Auswertung, BWA) in conjunction with the open item lists, that is, the schedules of invoices not yet paid. For growth companies, it shows how much capital additional revenue ties up before it leads to cash receipts.

Calculating the cash conversion cycle: formula and periods

• Days inventory outstanding (DIO): average inventory divided by the cost of materials or cost of goods sold for the year, times 365. Cost of goods sold is the purchase value of the goods sold. Days inventory equals 365 divided by the inventory turnover.
• Days sales outstanding (DSO): trade receivables divided by revenue, times 365.
• Days payables outstanding (DPO): trade payables divided by the cost of materials or cost of goods sold, times 365.

Formula: Cash conversion cycle = days inventory outstanding (DIO) + days sales outstanding (DSO) minus days payables outstanding (DPO)

The value is comparable only with a consistent delineation. In Germany, receivables regularly include value added tax, whereas revenue does not; without adjustment, days sales outstanding come out too high. Receivables are therefore adjusted beforehand for value added tax, that is, at the standard rate of 19% divided by 1.19. Average values from monthly data are better used than the balances on a single reporting date.

What the cash conversion cycle tells

A positive value means that the company pays suppliers before customers pay. Growth then ties up capital, roughly in proportion to the revenue increase. A negative value means that customers pay earlier than suppliers must be paid, for example with advance payment, subscriptions with annual prepayment or marketplaces that pass customer payments on to merchants only later. The business then partly finances its own growth; if revenue declines, this effect reverses.

Values differ considerably between industries. Trading companies are determined by days inventory, project businesses by down payments and acceptances, software vendors without inventory by days sales and days payables. What is meaningful is therefore above all the company's own development over several quarters and the comparison with companies of the same business model.

Steering and legal framework

Days sales outstanding fall through prompt invoicing, instalment payments, a binding dunning process in accounts receivable accounting and, where appropriate, the sale of receivables (factoring). Days inventory fall through assortment clean-up, smaller order quantities and adjusted safety stocks. Longer payment terms with suppliers raise days payables but often cost cash discounts. Anyone who does not use a 2% cash discount for payment 20 days before the due date forgoes a calculated annual return of around 37% (2 / 98 × 365 / 20).

The law sets limits on extending payment terms. Between businesses, a payment period of more than 60 days is effective under Section 271a(1) of the German Civil Code (BGB) only if it is expressly agreed and not grossly unfair to the creditor. Without a reminder, the debtor of a monetary claim falls into default at the latest 30 days after the due date and receipt of the invoice (Section 286(3) BGB). The consequences, in particular default interest, are described in the entry payment delay.

Significance in a funding round and a company acquisition

In a funding round, the cash conversion cycle explains part of the capital requirement. Investors distinguish whether the requirement arises from growth or from a capital tie-up that could be reduced through better management. In a company acquisition, acquirers evaluate the periods monthly for the last 12 to 24 months. From this, they derive the normal level of working capital. It enters as a target value into the working capital adjustment, the purchase price adjustment for deviations on the reference date. A shortening shortly before the reference date, for example through postponed supplier payments, is as a rule adjusted for.

Worked example: calculating the cash conversion cycle of a wholesaler

A wholesaler generates EUR 14.6 million in revenue a year, that is, EUR 40,000 per day, with a cost of goods sold of EUR 9.125 million, that is, EUR 25,000 per day. On annual average, there are inventories of EUR 1.5 million, receivables of EUR 1.8 million and supplier liabilities of EUR 750,000, each excluding value added tax.

• Days inventory: 1,500,000 / 9,125,000 × 365 = 60 days
• Days sales outstanding: 1,800,000 / 14,600,000 × 365 = 45 days
• Days payables outstanding: 750,000 / 9,125,000 × 365 = 30 days
• Cash conversion cycle: 60 + 45 minus 30 = 75 days
• Capital tied up: 1,500,000 + 1,800,000 minus 750,000 = EUR 2,550,000
• Days sales outstanding reduced to 35 days: receivables 35 × 40,000 = EUR 1,400,000, EUR 400,000 is released, the cycle falls to 65 days
• Revenue growth of 20% with an unchanged cycle: additional capital tie-up 2,550,000 × 20% = EUR 510,000

Shortening days sales outstanding by ten days releases funds once, which would otherwise have to be raised through financing. Conversely, the last line shows what amount the planned growth additionally ties up if nothing changes in the periods.

Distinction: cash conversion cycle, working capital and inventory turnover

• Working capital: the amount of capital tied up in current assets. The cash conversion cycle describes the same tie-up as a period in days.
• Liquidity: the ability to make payments when due. A short cycle relieves liquidity but says nothing about the account balance on a particular day.
• Inventory turnover: states how often the stock of goods is sold and replaced in a year. Days inventory in the cash conversion cycle expresses the same in days.
• Cash conversion: despite the similar name, a different metric, the ratio of operating cash flow to EBITDA. It measures what share of earnings arrives as payment, not the duration of the capital tie-up.

Common mistakes

• Only the balance sheet date. At the end of the financial year, inventory and receivables are often lower than during the year. A value calculated once a year conceals seasonal peaks.
• Gross and net mixed. Receivables including value added tax divided by revenue excluding value added tax overstate days sales outstanding.
• Improvement through late payment. Anyone who unilaterally pays suppliers later improves the metric only seemingly, loses cash discounts and risks default interest and supply terms.
• Only the total considered. Often a few product groups or customers cause the largest part of the capital tie-up. Only the breakdown shows where measures take effect.

Frequently asked questions

How is the cash conversion cycle calculated?

Days inventory plus days sales outstanding minus days payables outstanding, each in days. Inventories, receivables and payables come from the balance sheet or the open item lists, revenue and cost of goods sold from the income statement. During the year, the monthly closing and the management accounts provide usable values, provided changes in inventory are booked.

What is a good cash conversion cycle?

There is no generally valid target value. In principle: the shorter the cycle, the less capital growth ties up. The value can be compared above all with earlier quarters and with companies of the same business model. A value that stays stable or falls as revenue rises points to good management.

Can the cash conversion cycle be negative?

Yes. If customers pay in advance or on ordering and suppliers are paid only later, the value is negative. The company then has its customers' funds available before it bears the associated costs.

How much capital does one day of shortening release?

For days sales outstanding, roughly one day's revenue; for days inventory, roughly one day of cost of goods sold; an additional day of payment term with suppliers brings the same. The effect occurs once and remains as long as the shorter period is maintained.

The Roemer Capital view

Before a growth round, we evaluate the three periods monthly over at least two years. This makes it possible to evidence to investors which part of the capital requirement comes from growth and which can be avoided through management. An avoidable part that is noticed only in due diligence weakens the justification for the entire round size.

In a sale process, we prepare the same monthly series as the basis for negotiating the target value for working capital. Seasonal patterns and one-off effects are then explained before the acquirer takes them into its calculation.