Cash Conversion Cycle
Cash Conversion Cycle
Cash Conversion Cycle
The cash conversion cycle (CCC) is a metric that expresses the length of time, in
days, that it takes for a company to convert resource inputs into cash flows. The cash
conversion cycle attempts to measure the amount of time each net input dollar is tied up
in the production and sales process before it is converted into cash through sales to
customers. This metric looks at the amount of time needed to sell inventory, the amount
of time needed to collect receivables and the length of time the company is afforded to
pay its bills without incurring penalties.
Where: DIO represents days inventory outstanding, DSO represents days sales
outstanding and DPO represents days payable outstanding
The calculation of CCC involves several items from financial statements for a
certain period of time (generally 365 days for a year or 90 days for a quarter).
*Days Inventory Outstanding (DIO) refers to the number of days it takes to sell an
entire inventory. A smaller DIO is preferred. Days Sales Outstanding (DSO)
refers to the number of days needed to collect on sales, or accounts receivable.
A smaller DSO is also preferred. Days Payable Outstanding (DPO) refers to the
company's payment of its own bills, or accounts payable. By maximizing this
number, the company holds onto cash longer, increasing its investment potential.
Thus, a longer DPO is preferred.
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Days Sales Outstanding - DSO
Days sales outstanding (DSO) is a measure of the average number of days that
a company takes to collect revenue after a sale has been made. DSO is often
determined on a monthly, quarterly or annual basis and can be calculated by dividing
the amount of accounts receivable during a given period by the total value
of credit sales during the same period, and multiplying the result by the number of days
in the period measured.:
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Days payable outstanding (DPO) is a company's average payable period. Days
payable outstanding tells how long it takes a company to pay its invoices from trade
creditors, such as suppliers. DPO is typically looked at either quarterly or yearly.
The formula to calculate DPO is written as: ending accounts payable / (cost of
sales/number of days). These numbers are found on the balance sheet and the income
statement.
The average collection period is the approximate amount of time that it takes for a
business to receive payments owed in terms of accounts receivable. The average collection
period is calculated by dividing the average balance of accounts receivable by total net credit
sales for the period and multiplying the quotient by the number of days in the period.
Calculated as:
Where:
Days = Total amount of days in period
AR = Average amount of accounts receivables
Credit Sales = Total amount of net credit sales during period
A company has an average accounts receivable balance for the year of $10,000. Total net sales
during this period equal $100,000. The average collection period would be 36.5 days
(($10,000/$100,000)*365). This indicates that it takes just over 36 days to collect an A/R.
The average age of inventory is the average number of days it takes for a firm to sell off
inventory. The formula to calculate the average age of inventory is C/G x 365, where C is the
average cost of inventory at its present level, and G is the cost of goods sold (COGS).
Example: An investor decides to compare two retail companies. Company A owns inventory
valued at $100,000 and the COGS is $600,000. The average age of Company A's inventory is
calculated by dividing the average cost of inventory by the COGS and then multiplying the
product by 365 days. The calculation is $100,000 divided by $600,000, multiplied by 365 days.
The average age of inventory for Company A is 60.8 days. That means it takes the firm
approximately two months to sell a piece of inventory. Conversely, Company B also owns
inventory valued at $100,000, but the cost of inventory sold is $1 million, which reduces the
average age of inventory to 36.5 days. On the surface, Company B is more efficient than
Company A.
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Average Payment Period
The average payment period (APP) is defined as the number of days a company takes
to pay off credit purchases. It is calculated as accounts payable / (total annual purchases / 360).
As the average payment period increases, cash should increase as well, but working capital
remains the same. Most companies try to decrease the average payment period to keep their
larger suppliers happy and possibly take advantage of trade discounts. Since the average
payment period does not affect working capital, APP typically has little or no effect on the
valuation of a company or on a merger or acquisition. Recent economic trends have lead to the
average APP increasing because of the typical trickle-down effect of payments.
The economic order quantity (EOQ) is the order quantity that minimizes total holding
and ordering costs for the year. Even if all the assumptions dont hold exactly, the EOQ
gives us a good indication of whether or not current order quantities are reasonable.
EOQ Formula
Same Problem
Pam runs a mail-order business for gym equipment. Annual demand for the Trico
Flexers is 16,000. The annual holding cost per unit is $2.50 and the cost to place an
order is $50. What is the economic order quantity?
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Economic Order Quantity - EOQ
Economic order quantity (EOQ) is an equation for inventory that determines the ideal
order quantity a company should purchase for its inventory given a set cost of
production, demand rate and other variables. This is done to minimize variable
inventory costs, and the formula takes into account storage, or holding, costs, ordering
costs and shortage costs. The full equation is as follows:
S = Setup costs
D = Demand rate
P = Production cost
I = Interest rate (considered an opportunity cost, so the risk-free rate can be used)
The EOQ formula can be modified to determine different production levels or order
interval lengths, and corporations with large supply chains and high variable costs use
an algorithm in computer software to determine EOQ.
EOQ is an important tool for management to minimize the cost of inventory and the
amount of cash tied up in the inventory balance. For many companies, inventory is the
largest asset balance owned by the company, and these businesses must carry
sufficient inventory to meet the needs of customers. If EOQ can help minimize the level
of inventory, the cash savings can be used for some other business purpose.
One component of the EOQ formula calculates a reorder point, which is a level of
inventory that triggers the need to place an order for more inventory. By determining a
reorder point, the business avoids running out of inventory and is able to fill all customer
orders. If the company runs out of inventory, there is a shortage cost, which is the
revenue lost because the company does not fill an order. Having an inventory shortage
may also mean the company loses the customer or the client orders less in the future.
EOQ takes into account the timing of reordering, the cost incurred to place an order and
costs to store merchandise. If the company is constantly placing small orders to
maintain a specific inventory level, the ordering costs are higher, along with the need for
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additional storage space. Assume, for example, a retail clothing shop carries a line of
mens jeans and the shop sells 1,000 pairs of jeans each year. It costs the company $5
per year to hold a pair of jeans in inventory, and the fixed cost to place an order is $2.
The EOQ formula is the square root of: (2 X 1,000 pairs X $2 order cost) / ($5 holding
cost), or 28.284 with rounding. The ideal order size to minimize costs and meet
customer demand is slightly over 28 pairs of jeans. A more complex portion of the EOQ
formula provides the reorder point.
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