Understanding Cash Conversion Cycle (CCC)
Business owners may use the cash conversion cycle to measure the time the company requires to turn its resources into cash. This is especially important for small companies (Also see The Common Accounting Challenges SMEs Need to Deal With) as the cash conversion cycle helps in identifying time taken for it to generate cash. Thus, besides hiring an accounting firm in Johor Bahru to ensure that all your records are accurate and updated, you should also use this cycle to monitor the cash you have on hand to pay bills.
Note that the cash conversion cycle is different from the cash collection cycle. The cash collection cycle only include the number of days business owners need to collect the company’s accounts receivable. It does not take the time taken for the company to buy necessary materials and thus, cash collection cycle tends to be shorter than the cash conversion cycle.
The cash conversion cycle aims to help in determining the time required for your company to convert the funds you spent on purchasing resources into cash through selling the products produced and receiving the payments from your clients. When deriving the cash conversion cycle, the factors you should take into consideration include the average time you need to:
– Turn raw materials into final products
– Collect accounts receivables from your clients
– Settle supplier invoices
Thus, by taking the factors above into account, you may calculate the cash conversion cycle by adding up your days inventory outstanding (DIO) and your days sales outstanding (DSO), then subtract the days payable outstanding (DPO) from the amount calculated.
Among the factors above, days inventory outstanding it the one which is the most susceptible to considerable change. The sum of accounts receivable will not change significantly most probably, whereas the amount of accounts payable has been stated on the contracts with the suppliers. Thus, a savvy management team would choose to pay more attention to reduce the company’s investments in inventory.
Typically, business owners will use the cash conversion cycle to analyse how he can reduce the investment in the company’s working capital. As a result, he will be able to make several decisions from the policy and operational perspective. Some examples include:
– Stop selling products that make poor sales so that the company can cut down the amount of supporting inventories.
– Implement a just-in-time production system that minimises the labour, time, as well as materials needed in production by only producing the product they need. Doing so helps in reducing investment in inventory.
– Outsource the manufacturing process to cut down inventory investment.
– Make adjustments in the process of collecting receivables so that the related staff will contact the clients more often for overdue payments.
– Establish a tighter credit policy which helps in decreasing billings to clients who are more likely to make late payments.
– Negotiate a longer payment term with the suppliers.
If the cash conversion cycle for the company is short, it means that the company can operate without needing a huge amount of cash. Hence, it is ideal to have a short conversion cycle. A company that can achieve this compared to those of the same kind may have been reviewing the whole process continually over a long period. A responsible manager should at least monitor the cash conversion cycle by using a trend line. Whenever there is a sign whenever the company needs more time to turn invested funds into cash, he should take action to solve the problem.
Smaller companies will also track this cycle closely as they have a small amount of debt or equity funding. Hence, they should be careful of the way they use their cash (Also see 5 Accounting Tips for Small Businesses). Most of the time, non-profit organisations will encounter this problem as they do not have much cash reserve (Also see Are Accounting Treatments for Profit and Non-profit Organisation the Same?).