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Why the Cash Conversion Cycle is a powerful and important Key Performance Indicator (KPI)?
We have all heard the term ‘cash is king’ and a business survives on its cash not profit.
The Cash Conversion Cycle (CCC) measures the total number of days from the payment of cash for goods and / or services until the receipt of cash for the same goods or services.
You are in the construction business.
On average, you purchase raw materials on credit terms of 60 days (i.e., you must pay for them in 60 days)
The raw materials that you purchase on average take 90 days to sell (i.e., the timber and concrete that you purchase take 90 days before they are sold or the project is completed and the client / customer invoiced)
On average, it takes your customers / clients 75 days to pay you (i.e., once you have finished a project it takes 75 days for your clients / customers to pay you)
The combination of the above gives you the average number of days that cash is invested in your business. By improving this measurement, you can free up cash and use it for other purposes.
The formula for Cash Conversion Cycle is CCC = DIO + DSO - DPO
DIO: Days Inventory Outstanding
DSO: Days Sales Outstanding
DPO: Days Payables Outstanding
So in the above example: 90 + 75 – 60 = 105 days. The average number of days your cash is invested / tied up in your business is 105 days.
The smaller the result the better for the business.
Although the CCC is a very powerful and important measurement, (incorporating the balance sheet and profit and loss statement), it should not be pursued without consideration for anything else.
You might improve your cash flow by increasing your sales but this was simply done by reducing prices. Whilst you are improving your cashflow, you are sacrificing your profit.
Or you might start to become increasingly strict with your payment terms, causing harm to customer relationships.
You may try to reduce the amount of inventory that you are holding. Whilst this will reduce your overall average cash commitment in inventory, your projects may experience delays and this will affect your ability to complete jobs and issue invoices to your customers / clients.
You may try to stretch out the time you take to pay your suppliers. This strategy may place strain on your supplier relationships and limit your ability to acquire additional products / materials.
It is important that the CCC is used in conjunction with other KPI’s to measure your business performance.
If you would like to discuss further please contact us:
McNamara and Co - Chartered Accountants, located minutes from the Melbourne CBD
Phone +61 3 9428 1062