I recently wrote an article for the local chapter of Associated Builders and Contractors on certain financial statement metrics that are valuable to construction companies. One measurement that I did not include because of space constraints is worthwhile for all entities to consider. It is called the Cash Conversion Cycle (CCC).
The Cash Conversion Cycle illustrates how long it takes a company to turn its resources into cash. The lower the CCC, the more quickly cash is retained. It takes into consideration three other metrics: (1) days sales outstanding [DSO]; (2) days inventory outstanding [DIO]; and (3) days payables outstanding [DPO].
Receivables, inventory and payables are three components of current ratio and working capital, but CCC analyzes them in a deeper manner. Generally, higher receivables and higher inventory will lead to attractive current ratio and working capital, but they may also be indicative of poor turnover in those areas and a slow transformation of these accounts into cash.
The calculation of CCC is relatively simple: DSO + DIO – DPO. Days sales outstanding is calculated by taking the sales divided by average receivables for the year. This yields A/R turnover. Taking 365 days divided by A/R turnover results in DSO. Similarly, DIO is 365 divided by inventory turnover, where inventory turnover is cost of sales divided by average inventory. Lastly, DPO is 365 divided by A/P turnover (cost of sales divided by average payables).
A number of years ago, Apple actually had a negative CCC. This phenomenon is rare, and it indicates that customers are giving Apple cash before Apple has to pay its vendors. It’s a good position to be in. Successful general contractors on fixed-price jobs may likewise have low CCCs because of being able to control the cash on the contract by collecting from the customer before paying subcontractors. Subcontracting firms, on the other hand, may have higher CCCs because they often have less control over the cash in a job.
Although CCC is a good measure of cash flow, it is not necessarily a great indicator of short-term success. If a company can do well in its collection of receivables and has little inventory but spends a lot on capital expenditures or debt obligations, it may not have excess cash to pay down accounts payable. This company will have great CCC because it is turning over A/R quickly and not turning over A/P quickly at all. Even so, it may have poor capital because of having large liabilities.
With that caveat, in the long run, CCC will mirror balance sheet strength, so controllers and CFOs should include CCC in their monthly and annual evaluation of their balance sheet. Cash has long been considered the chief asset on a balance sheet, and any metric that measures how cash can be maximized will be useful to any company.
By Dan Massey, CPA, Manager