What it means
Each component converts a balance sheet number into a length of time. Receivables become the average number of days customers take to pay, inventory becomes the average number of days stock sits before it is sold, and payables become the average number of days the company takes to pay its own suppliers.
Adding the first two and subtracting the third gives the cash conversion cycle. The appeal of days over dollars is comparability.
A company with $1,000,000 of receivables may be efficient or dreadful depending on its sales volume, but 50 days is immediately meaningful and can be compared with last year, with the terms printed on the invoice and with competitors of any size. It also translates straight back into money, because one day of the cycle equals one day of revenue or cost.
This matters most in growing businesses and in any company with thin cash reserves. Cutting the cycle by ten days releases ten days of trading cash permanently, which is often cheaper and quicker than arranging a loan.
It is one of the few finance levers that improves liquidity and return on capital at the same time. In practice the ratios are calculated from average balances over the period rather than a single year-end snapshot, because a seasonal business looks very different in March and October.
Days payable outstanding is normally calculated against cost of goods sold or total purchases rather than revenue, since that is what suppliers actually invoice. Mixing a revenue base and a cost base across the three ratios is the most frequent error.
A negative cash conversion cycle, where customers pay before suppliers are paid, is the prize. Supermarkets and many subscription businesses operate this way and are effectively financed by their own trading, but for everyone else the aim is a steadily shortening cycle rather than a specific target number.
In practice
Real-world examples.
Example
A commercial printer with a 95-day cash conversion cycle wins a large contract and realises it cannot fund the paper purchases. Rather than borrowing, it negotiates 45-day supplier terms in place of 30 and asks the client for a 25% deposit, which cuts the cycle to 62 days and removes the funding gap.
Example
A grocery chain reports 5 days of inventory, 2 days of receivables and 38 days of payables, giving a cash conversion cycle of minus 31 days. Customers pay at the till long before suppliers are settled, so expansion is partly financed by suppliers rather than by the bank.
Example
A private equity firm reviewing a manufacturing target finds days sales outstanding of 78 against invoice terms of 30 days. It builds a collections improvement into the first hundred days of the investment plan, valuing the released cash at roughly $1,400,000 on the target's revenue base.
Think of it
“Working capital days shows how much operating capital is tied up in terms of days of sales.
Formula
Calculation
Days sales outstanding = receivables / revenue x 365
Days inventory outstanding = inventory / cost of goods sold x 365
Days payable outstanding = payables / cost of goods sold x 365
Cash conversion cycle = days sales outstanding + days inventory outstanding - days payable outstanding
An equipment distributor has annual revenue of $7,300,000 and cost of goods sold of $4,380,000. That gives daily revenue of $7,300,000 / 365 = $20,000 and daily cost of $4,380,000 / 365 = $12,000.
Receivables of $1,000,000: $1,000,000 / $20,000 = 50 days
Inventory of $720,000: $720,000 / $12,000 = 60 days
Payables of $480,000: $480,000 / $12,000 = 40 days
Cash conversion cycle = 50 + 60 - 40 = 70 days
The company funds 70 days of trading out of its own resources. Collecting 10 days faster would release 10 x $20,000 = $200,000 of cash, and holding 5 fewer days of stock would release a further 5 x $12,000 = $60,000, giving $260,000 without a single extra sale.Case study
Seen in the real world.
The following is a fictional illustration. Penhale Textiles, an invented mid-sized fabric supplier, was profitable but permanently close to its overdraft limit, and the finance director's usual answer was to ask the bank for more headroom. A working capital review measured the cycle for the first time: 68 days of receivables, 84 days of inventory and 32 days of payables, giving a cash conversion cycle of 120 days.
At daily revenue of $30,000 and daily cost of $18,000, that meant more than $3,500,000 of cash was permanently locked into the operating cycle. The team set a target of 90 days over twelve months and picked three actions: invoice on despatch rather than at month end, discontinue 200 slow-moving fabric lines, and move the two largest suppliers from 30-day to 45-day terms.
Twelve months later receivables were at 52 days, inventory at 66 and payables at 44, giving a cycle of 74 days. Roughly $1,300,000 of cash had been released, the overdraft was repaid and the interest saving alone added noticeably to profit. In this illustrative case nothing was sold differently; the money had simply been sitting in the warehouse and in customers' accounts.
Watch out
Common mistakes.
- Calculating days payable outstanding against revenue instead of cost of goods sold. Suppliers invoice you for costs, not for your selling prices, so a revenue base understates the true payment period.
- Using year-end balances for a seasonal business. A December stock count in a business that peaks in July produces a days figure that describes the quietest week of the year.
- Chasing a shorter cycle by simply paying suppliers later. Beyond agreed terms this damages relationships, forfeits settlement discounts and can cost more than the financing it saves.
Questions
People also ask.
What is a good cash conversion cycle?
It depends entirely on the sector, since retail often runs negative while capital equipment makers routinely run over 100 days, so compare against your own trend and close competitors.
Should days be based on 365 or 360?
Either works provided it is applied consistently, though 365 is more common outside banking and gives a slightly more conservative figure.
How much cash does one day of the cycle represent?
Roughly one day of revenue for the receivables element and one day of cost of goods sold for the inventory and payables elements.
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