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Cash Conversion Cycle: What Is It and How Can You Improve It?

woman in retail shop thinking about the cash conversion cycle

The cash conversion cycle is a way to measure the amount of time it takes a company to convert its cash on hand to additional cash. The process includes purchasing or creating inventory, selling it and eventually getting paid. Here we explore how to calculate the cash conversion cycle and how to improve it.

Turning money into more money

Businesses go through a process where they use money to create products and services with the goal of getting more money in the end by selling these products or services. The challenge is the time it takes to do this, which is called the cash conversion cycle (CCC). When this process takes too long, it diminishes a company’s cash flow and working capital. 

The first step in improving the CCC is to measure it. We can do this with the cash conversion cycle formula:

Days inventory outstanding + Days sales outstanding – Days payables outstanding

Let’s take a closer look at the factors that make up the cash conversion cycle equation. 

Days inventory outstanding (DIO): This measures the number of days, on average, it takes to sell all the inventory. The equation for determining DIO is (Cost of average inventory ÷ Cost of goods sold) x 365. The smaller the DIO, the better for reducing the CCC. Learn more about it in What Are Days Inventory Outstanding? 

Days sales outstanding (DSO): This measures the number of days it takes to collect cash after invoicing customers. The smaller this number, the better it will be for reducing the cash conversion cycle. For more information, including how to calculate the DSO, check out Days Sales Outstanding and How to Measure It

Days payable outstanding (DPO): This is the average time it takes in days to pay invoices it owes to other businesses. 

While we want to reduce DIO and DSO to reduce the cash conversion cycle, we want to increase the days payable outstanding at the same time. 

How to reduce your cash conversion cycle

Now that we know the cash conversion cycle calculation formula, we can consider ways to reduce it by focusing on the individual components.

How to reduce days inventory outstanding

Days inventory outstanding can be reduced a number of ways, including: 

  • Improving planning and forecasting – by knowing how much inventory you will need at different times, you can decrease the time inventory is stored before it is sold. 
  • Increasing sales – boosting sales and marketing activities can convert inventory into cash faster. Discounts can also be used when inventory levels are too high. 
  • Optimise inventory levels – using an inventory management system can help you maintain the optimal inventory levels so you don’t have too much stock but don’t end up short-handed to meet demand. 

Find out more in Inventory Management: A Short Guide for SMEs

Steps to reduce days sales outstanding to improve the cash conversion cycle

Reducing days sales outstanding can be achieved a number of ways:

  • Create and implement credit policies and procedures – these are a roadmap to help you start out right with new customers and better manage your accounts receivable. Policies and procedures can include ways to approve new customers for credit sales (such as credit score and reference checks) and the collection process. Learn more about creating credit policies and procedures.  
  • Invoice immediately when goods or services are delivered – when you invoice straight away after delivering goods or services, it creates a sense of urgency and enables customers to connect the invoice to what you have provided. 
  • Make it easy for customers to pay you – this will help to reduce days sales outstanding. Offer several ways to pay, including bank transfers, credit cards and cheques. Create an invoice design that’s easy to read and clearly shows the amount due. Include your contact details on the invoice for customers to get in touch if they have questions. 
  • Send out reminders when payments are late – research has shown that reminders speed up invoice payments. One study by ezyCollect found that 59 per cent of overdue invoices require three or more follow-ups before they’re paid. Some accounting programs can be set up to automate reminders when invoices are overdue. 

Implementing these steps can help you decrease the cash conversion cycle.

Increase days payable outstanding

This one is fairly simple. To increase you days payable outstanding, pay invoices just before the due date. Paying invoices earlier than necessary will reduce days payable outstanding. You can also request longer payment terms from suppliers. For example, if a supplier has 15-day terms, ask for 30 days. These two steps can help you extend your accounts payable and reduce your cash conversion cycle. 

A new solution for shortening the cash conversion cycle

If you have a long cash conversion cycle that’s impacting your cash flow and limiting business growth, Moula Pay is a finance option that can help. When you sell to other businesses and your customers pay with Moula Pay, your business gets paid upfront. At the same time, your customers have up to 12 months to pay, with the first three months interest and repayment-free.

When you become a Merchant with Moula Pay, you can:

  • Get paid upfront – give your customers excellent payment terms that improve your cash flow.
  • Stop chasing payments – outsource the pain of chasing invoices, and let Moula take the risk of unpaid invoices
  • Sell more, more often  – giving your customers access to more funds means they can spend more with you.

Learn more about how Moula Pay can give your customers great payment terms, improve your cash flow, and decrease your days sales outstanding.

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Business content for Australian SMEs. Sharing guides, growth hacks, and expert tips on finance, sales and marketing, and tech.

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