Lesson 7 of 7
The cash conversion cycle
The days between paying a supplier and being paid by a customer. A negative cycle means suppliers fund growth, and it drains cash when sales fall.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- The cycle is days of inventory plus days of receivables less days of payables: how long a company's own cash is tied up before it returns.
- A negative cycle means suppliers fund the growth: the float stops adding cash when growth stops, and drains cash when sales fall.
- The three components use two different denominators, so the cycle is an approximation, not an exact number of dollars.
The cash conversion cycle is the number of days a company's own cash sits in stock and in unpaid customer bills before it comes back. Shorter means growth needs less cash. Below zero, suppliers are funding the business.
One company's cycle, three components
- Days inventory outstanding73.0 days
- Plus days sales outstanding+54.8 days
- Less days payables outstanding−54.8 days
- Cash conversion cycle= 73.0 days
Three days, two denominators
Days sales outstanding is receivables scaled by revenue. Days inventory outstanding and days payables outstanding are scaled by cost of revenue. The cycle adds terms measured against two different denominators, so converting it back into an amount of cash gives a different answer depending on which one is used, and neither answer matches the working capital actually on the balance sheet.
Seventy-three days is one fifth of a year. A fifth of this company's revenue of 1,000 is 200; a fifth of its cost of revenue of 600 is 120; and the working capital actually tied up, receivables of 150 plus inventory of 120 less payables of 90, is 180. Three figures for one balance sheet, and only the last is a balance sheet fact. Use the cycle as a number of days and compare it to the company's own history; when someone converts it into cash that would be released by shortening it, ask which denominator they used.
Positive and negative cycles
A manufacturer, 75 days
- Collects in 45 days, holds stock 60 days, pays suppliers in 30.
- Its own money is committed for 75 days on every turn.
- Growth consumes cash.
A retailer, minus 17 days
- Collects in 3 days, holds stock 40 days, pays suppliers in 60.
- Cash from a sale arrives 17 days before the supplier is paid.
- Growth releases cash; suppliers fund the expansion.
The same three days, added in the same order, describe opposite financing positions.
A negative cycle is a financing structure, and it runs backwards
While a negative-cycle business grows, the supplier float grows with it, and that cash shows up in operating cash flow indistinguishable from operating performance. When growth stops, the float stops growing and its contribution goes to zero. When revenue falls, the float unwinds. The company is still paying for goods bought when volumes were higher, while collecting on lower current sales, so working capital consumes cash exactly when the business can least afford it. That mechanism is behind a pattern: a fast-growing retailer with strong operating cash flow and thin liquidity ratios whose cash position deteriorates quickly in its first bad year.
What moves the ratio without moving the business
Selling receivables to a third party removes them from the balance sheet and shortens days sales outstanding immediately, with no change in when the customer actually pays. Supply chain finance does the equivalent at the other end: a bank pays suppliers early and the company settles with the bank later. This lengthens days payables outstanding and can leave the obligation inside trade payables rather than borrowings, outside every leverage ratio as well. Supplier finance programmes must now be described in the notes; receivable sales are described when material. Neither shows in the ratio.
Check yourself
A retailer has a cash conversion cycle of minus 17 days. What does that mean?
- The retailer is losing 17 days of cash on every sale
- Cash from a sale arrives before the retailer has to pay its own supplier for the goods
- The retailer's inventory turns over in 17 days
Show the answer
Answer: B.
A negative cycle means the company collects from customers and holds stock for fewer combined days than it takes to pay its own suppliers, so growth releases cash rather than consuming it.A company's cash conversion cycle stays flat at 50 days for five years. What can you conclude?
- None of its three components changed
- Nothing on its own; two components can move by equal and opposite amounts and cancel
- The company's working capital position is unchanged
Show the answer
Answer: B.
Days sales outstanding and days payables outstanding can both lengthen by the same amount, leaving the sum unchanged while customers are taking longer to pay and the company is taking longer to pay its own suppliers.Why can the same cash conversion cycle be converted into two different dollar amounts?
- Because the formula is wrong
- Because its components are scaled by two different denominators, revenue and cost of revenue
- Because inflation changes the value of a day
Show the answer
Answer: B.
Days sales outstanding is scaled by revenue while the inventory and payables terms are scaled by cost of revenue, so the cycle is a sum of terms in two units and does not convert cleanly into one dollar figure.Sources
- Fridson and Alvarez, Financial Statement Analysis, on statements prepared by parties with an interest in the impression they create.
What this leaves out
- The cycle is built from balance sheet snapshots against full-year flows, so a seasonal business is badly served by a single annual reading; quarterly filings give more observations.
- The three components use two different denominators, so the day counts are not strictly additive and the cycle is an approximation.
- Every figure on this page is a round invented input. Banks, insurers and REITs have no cash cycle in this sense and the figure is withheld for them.
- Nothing here is advice about any security.