M&A Vocabulary – Understanding the Experts: „Cash Conversion Cycle”

Working capital management is one of the most frequently neglected aspects in the finance area of many companies. Often, working capital is not optimized because neither the necessary knowledge nor the necessary attention is present. Many companies do not monitor the necessary performance indicators and thus forfeit significant cash optimization potential.

What is the Cash Conversion Cycle?

The Cash Conversion Cycle (CCC) is a performance indicator that companies can use to monitor their working capital management and thereby optimize their cash flow. The metric shows how many days it takes until investments in inventory flow back to the company as cash. It is expressed in days required to sell existing inventory to customers (Days of Inventory Outstanding (DIO)), receive payments from customers for delivered goods (Days Sales Outstanding (DSO)), and pay suppliers for raw materials, etc. (Days Payables Outstanding (DPO)). While DIO and DSO relate to the company’s cash inflow, the DPO metric correlates with cash outflow. Thus, the CCC can be summarized in the following formula:

Cash Conversion Cycle = DIO + DSO – DPO

The first part, DIO, indicates how long it takes for the company to sell its inventory. The formula for DIO is as follows:

DIO = Average Inventory / Cost of Goods Sold × 365 days

An increase in DIO means it takes longer for the company to sell its inventory. The smaller the DIO, the faster the company sells its inventory. This may be due to high demand for the company’s products. Especially after crisis periods, it can be worthwhile to critically review inventory levels so that low stock does not prevent the company from serving customer demand.

The second part, DSO, captures the time customers need to pay the company for purchased goods and services. The formula for DSO is:

DSO = Average Accounts Receivable / Total Credit Sales × 365 days

If cash payment is the predominant payment method in a company, this metric equals 0. Typical payment terms in the B2B sector are approximately 30 days, as customers usually pay by invoice and thus receive a form of short-term financing for their purchases. To manage the company’s cash flow, quick payment by the customer—i.e., a low DSO—is favored in order to be able to pay suppliers without external financing. An increase in DSO may indicate that payment collections are not being carried out properly. Customers are not paying on time, or the company is extending payment terms to secure a deal. In this case, a thorough analysis of the underlying circumstances should be conducted.

The last part of the formula, DPO, is the average number of days a company needs to pay its suppliers. The formula is as follows:

DPO = Average Accounts Payable / Cost of Goods Sold × 365 days

An increase in DPO is actually advantageous, as a company has more time to collect payments from its customers to settle invoices from its suppliers.

Overall: The shorter the CCC, the lower the company’s interim financing needs. The processing of intermediate products, the sale of inventory, and the recovery of cash from these sales proceeds occur quickly, so that suppliers can be paid in the short term and this period can usually be managed without external financing. In contrast, a rising CCC can indicate several operational challenges that must be analyzed (e.g., slow-moving inventory due to low-demand products, key accounts that may be in financial distress, or unfavorable payment terms from suppliers).

Effective Working Capital Management as an Advantage with Investors

Beyond the operational management of the company, the metric is also of high interest to other stakeholders (e.g., investors, credit analysts, banks, etc.). Tracking the CCC over several quarters can provide insight into the importance of working capital to management, the optimization potential in this area, seasonality, or the potential cash reserves that must necessarily be maintained.

How well working capital is managed can be monitored in various ways. Starting from an analysis of the CCC over multiple periods, the ratio can be compared with industry best practices or competitors.

Potential Optimization Opportunities

Optimization potential can be realized in various ways, affecting DSO and DPO, for example. Possible methods for reducing DSO include:

• Automated invoicing;
• Short standard payment terms;
• Down payment requirements for custom work;
• Discounts not tied to product sales.

In addition to these examples, a frequently used tool for reducing DSO is factoring. Factoring means that a company sells its receivables at a discount to a third party, which then collects payments from a business customer. Depending on the discount, this can be a way to optimize working capital and, in particular, secure quick liquidity inflow for companies in financial distress. Possible actions to increase DPO include:

• Automated invoice scanning;
• Standard payment terms;
• Fixed payment cycles (e.g., twice per month);
• Optimization of supplier relationships.

Based on these considerations, the question arises whether it is possible to generate a negative CCC. This is possible and means that the company receives money in advance or faster from its customers than it needs to initiate payments to suppliers.

“Cash is King,” Especially in Times of Crisis

What role does the CCC play in relation to the economic conditions following the global COVID-19 pandemic?

For many companies, the CCC will rise as DIO increases due to the downturn in operations and thus higher inventory levels (e.g., clothing that cannot be sold due to store closures). Customers may not be able to pay on time, which will affect DSO. Suppliers may want to receive payments in advance due to high economic uncertainties. Overall, the CCC will increase, making it even more important for companies in times of crisis to understand and optimize their working capital management.

Crises Should Not Be Wasted

Careful use of the CCC could also have positive effects, for example, influencing customer loyalty and thus increasing market share in volatile industries. Increasing inventory during times of low demand could enable a company to gain market share during the recovery phase, as it could be one of the few companies able to satisfy suddenly rising demand. Creditors/customers should be thoroughly analyzed. Some may be in economic distress and therefore grateful for loyalty and support during a crisis. Increasing payment terms with these customers could initially increase DSO and thus the CCC. In the long term, however, this approach could secure a long-term customer relationship. It is also important to build trust with suppliers during a crisis. Transparent handling of current business information and communication of financial figures despite uncertainties are key to building trust and can also lead to long-term benefits in this case.

Conclusion

In summary, an active approach to managing the CCC—analyzing inventory levels, developing and maintaining long-term customer relationships, and further building trust with business partners—can prepare companies to optimally benefit from the economy’s recovery path.

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