Cash Conversion Cycle (CCC) measures ongoing liquidity from the firm’s operation is defined as a more comprehensive measure of working capital and as a supplement to current ratio and quick ratio. CCC shows the time lag between expenditure for the purchases of raw materials and the collection of sales of finished goods. CCC is a measure of the efficiency of Working Capital Management as it indicates how quickly the current assets are converting into cash. CCC comprises three components of days inventory outstanding (DIO), days sales outstanding (DSO), and days payables outstanding (DPO);
Cash Conversion Cycle (CCC) = Days Inventory Outstanding (DIO) + [Days Sales Outstanding (DSO) -Days Payables Outstanding (DPO)]
- Days Inventory Outstanding (DIO) is a key figure that measures the average amount of time that a firm holds its inventory. It is calculated by inventory/cost of sales x 365 days. A decrease in the DIO represents an improvement, an increase in deterioration.
- Days Sales Outstanding (DSO) is the key figure that measures the average amount of time that a firm holds its account receivables. It formula to calculate is account receivables/sales x 365days. A decrease in DSO represents an improvement, whereas an increase represents deterioration.
- Days Payables Outstanding (DPO) is the key figure that measures the average amount of time that a firm holds its trade payables. It is calculated by trade payable/cost of sales x 365days. For DPO, an increase in days represents an improvement, whereas a decrease indicates deterioration.
The traditional view on Cash Conversion Cycle (CCC) and profitability highlights that the shorter the CCC, the superior the firm profitability. The firm can shorten its CCC by improving the inventory turnover, collects cash from receivables more quickly, and slowing down the payments to suppliers. This will increase the efficiency of the firm internal operation and result in greater profitability. This can be seen in the case of Dell, which is mainly business is sales of its own brand (Dell) computer and computer accessories through internet and open door sales. Their primary focus is on the student market and home users. Analysis of Dell’s working capital showing that the increase in inventory turnover and receivable turnover days were affected Dell’s overall profitability. Later in the year 1997, Dell had made some changes to its business operation by only producing those computers when the order is placing by customers, and thus, the company able to reduce its CCC to negative working capital due to low inventory turnover. The negative CCC show that Dell is able to collect payments from customers before they made payment to their supplier.
On the other hand, shortening the Cash Conversion Cycle (CCC) could harm the firm’s profitability as reducing the inventory conversion period could increase the shortage cost, reducing the receivable collection periods could make the company’s losing its good credit customers, and lengthening the payable period could damage the firm’s credit reputation. Therefore, shorter cash conversion cycles associated with high opportunity cost, and longer cash conversion cycles associated with high carrying cost. By achieving the optimal levels of inventory, receivable, and payable will minimize both carrying cost and opportunity cost of inventory, receivable, and payable and maximizes sales, and profitability of firms. In this regard, an optimal cash conversion cycle a more accurate and comprehensive measure of working capital management. Optimum liquidity position, which is the minimum level of liquidity necessary to support a given level of business activity. Briefly, he says it is critical to deploy resources between working capital and capital investment because the return on investment is usually less than the return on capital investment. Therefore, deploying resources on working capital as much as to maintain optimum liquidity position is necessary. Then he sets up the relationship between CCC and minimum liquidity required such that if the CCC lengthens, the minimum liquidity required increases; conversely, that if the CCC shortens, the minimum liquidity required decreases.