Cash Conversion Cycle

The cash conversion cycle measures how long capital is tied up in operations before it flows back as cash. It covers the period from paying for inventory through the sale to the receipt of customer payments. The shorter the cycle, the less working capital the company needs to maintain. It is calculated as days inventory outstanding plus days sales outstanding minus days payable outstanding.

An example makes the point: if goods sit in stock for 60 days, customers pay after 45 days and the company settles supplier invoices after 30 days, the cycle is 75 days that must be pre-financed. The figure can also be negative where customers pay early and suppliers grant long terms, as can occur in food retail. Such companies partly fund their growth from their own business model. The metric is most informative over time and within a sector, because absolute levels depend on business model and seasonality. In transactions it matters twice over: it shows improvement potential a buyer can realise through better working capital management, and it is a warning signal where a seller shortens the cycle artificially before the reference date, for instance by delaying supplier payments or pushing collections.

Working capital is therefore analysed monthly in financial due diligence, and a normalised target level for the purchase price adjustment is derived from it. Looking at the three components separately is worthwhile in management, because each has different levers and limits: inventory days can be influenced through product range and planning, receivable days through contract terms and collections, payable days only to a limited degree without endangering supplier relationships and early payment discounts. Seasonality also matters, since the same business shows very different figures over a year. The analysis only becomes reliable on a monthly basis.