Cash Conversion Cycle Indicates the time taken by the company to convert the inventory into Liquid Cash in hand
Cash Conversion Cycle = Days Inventory Outstanding + Days Receivable Outstanding – Days Payable Outstanding
Company ABC has the Days Inventory Outstanding of 35 days and Days Sales Outstanding of 40 days and Days Payable Outstanding of 50 days. Then the cash conversion cycle is 25 days.
Company ABC takes 25 days to convert its inventory into liquid cash in hand.
How to use it practically
The cash conversion cycle is used at assessing how efficiently a company is managing its working capital. If the cash conversion cycle is negative then it shows that the company is able to get money in advance before it sells its inventory/products. This is a classical sign of good working capital management by the company. If the cash conversion cycle is very high and is increasing means that, the company is not able to collect money in a given time efficiently.
Investors should always look for companies that have low or negative cash conversion cycles. The market always rewards companies with a negative cash conversion cycle. If you are someone looking to invest in small-cap companies then this filter of negative cash conversion cycle will be very much useful.
The shorter the cash conversion cycle, the better the company is at selling inventories and recovering cash from these sales while paying suppliers.
The cash conversion cycle should be compared to companies operating in the same industry. And also, the Cash conversion cycle should be compared with the same company five years ago to get a better understanding of working capital management improvement done by the management of the company.