Regarding ecommerce, balancing between having enough inventory to sell and over-stocking inventory can be tricky.
So, how can you ensure that your inventory turnover is up to scratch, that your supply chain is working efficiently, and that your cash flow behaves as it should? The answer is to better understand your cash conversion cycle (CCC).
Cash conversion metrics can help you determine how efficiently and quickly you’re turning your inventory into profit. Here, we’ll go through a cash conversion cycle, its essential components, and how you can improve yours to create a streamlined and profitable system.
Table of Contents
Defining the cash conversion cycle
The cash conversion cycle represents the days it takes for a business to transform investments (typically into its inventory) into cash flow. A typical cycle will go something like this:
There’s a relatively simple formula for calculating it:
Days inventory outstanding + Days sales outstanding – Days payable outstanding =
Your cash conversion cycle
- Days inventory outstanding (DIO) is the average number of days a company holds inventory before selling it.
- Days sales outstanding (DSO) is the average number of days it takes for a company to collect payment after a sale.
- Days payable outstanding (DPO) is the average number of days a company takes to pay its ‘payables’ (e.g., invoices from suppliers).
We’ll go into the components of a cash conversion cycle in more detail. First, let’s look at why it’s important to understand yours.
The benefits of a cash conversion cycle in eCommerce
The cash conversion cycle is critical to ensuring your company keeps inventory current and optimizes its cash flow.
Here are just some of the benefits of having a good CCC.
It provides eCommerce liquidity for smoother operations
Liquidity can be complicated in eCommerce, but it’s much easier to understand and generate if you have a good knowledge of your cash conversion cycle.
In eCommerce terms, market liquidity can be defined as ‘the probability of a seller selling an inventory item to a buyer who wants it.’ It’s a bit tricky because market liquidity is hard to nail down at the best times. Your eCommerce business will have more liquidity if many people search for your items and you’re regularly selling them to searchers.
Understanding your cash conversion cycle gives you insight into which products sell the fastest, which in turn helps you understand (and generate) market liquidity. More liquidity means a smoother, more profitable operation all around.
The amount of liquidity you have also has an impact when evaluating the value of your business, so don’t take this lightly.
It efficiently manages working capital by optimizing cash flow
When you understand your cash conversion cycle, you’re also much more efficient at managing your working capital.
For example, you can adjust your cycle so accounts payable go out around the same time as you have many accounts receivable coming in. This helps you keep your cash flow healthy and means you will always have a decent amount of working capital available.
It balances short-term assets and liabilities for improved finances
Balancing assets and liabilities is key to keeping your business finances healthy, and it’s much easier to identify short-term assets and liabilities when you understand your cash conversion cycle.
For example, if a product flies off the shelves and tends to get paid for quickly, it’s a short-term asset. If you have payable accounts that take a hefty chunk of your capital, they’re liabilities.
Both of these features are in your CCC. Monitoring this cycle can help you balance them effectively for improved finances.
It quickly identifies and resolves potential financial challenges
If your cash conversion metrics change, it could be a warning that something is wrong. The market for a particular product may have died, or there may be issues with a supplier. Whatever it is, these metrics can be an early indicator of the problem.
Spotting issues as soon as possible helps you resolve them faster and get things back on track before your business or customers are impacted.
It accelerates accounts receivable collection for timely cash inflow
The second stage of a typical cash conversion cycle is “receivables”, where a business waits for payment following a sale.
Understanding your cash conversion cycle gives you insights into your accounts receivable process. You can use these to fine-tune your collections for optimal and timely cash inflow.
It strengthens vendor relationships and improves contract terms
A lot of friction between vendors and associates, like suppliers, couriers, and so on, is down to problems with the cash conversion cycle. Perhaps inventory isn’t being restocked fast enough to sell, or suppliers aren’t paid promptly. Issues like this can cause big problems for your relationships.
Understanding your cash conversion cycle helps you set more achievable expectations and contract terms with your associates. For example, if your CCC indicates that a particular product takes a long time to sell, you can speak to the supplier about more realistic order volumes and schedules. This ensures that everyone in your supply chain knows where they stand and what to expect from you.
Components of the cash conversion cycle
Now, to better understand your cash conversion cycle, let’s look at its essential components.
“Inventory days” refers to an item's time in your inventory. For example, if you receive a product on May 1st and it’s shipped out to a purchaser on the 10th, this equates to nine inventory days.
Accounts receivable days
“Accounts receivable days” refers to the time it takes to receive payment for a product. For example, if an item is shipped on the 1st of May and payment is received on the 3rd, it will have spent two days as an account receivable.
Accounts payable days
“Accounts payable days” refers to the time between receiving goods or services for your business and paying for them. For example, if a courier ships something for you on the 1st of May and you pay them for it on the 10th, it will have been payable for nine days.
Strategies for improving your eCommerce cash conversion cycle
A low (or, ideally, negative) cash conversion cycle is something to aim for. Here’s how you can get your CCC down.
Optimize inventory turnover to manage cash flow more efficiently
The higher your inventory turnover, the faster your cash conversion cycle. There are several ways to optimize this, including:
- Good inventory management techniques ensure you only order what you need when needed.
- Running loss-leader campaigns to reduce excess stock and bring in new customers.
- Cutting down on costs.
- Automating shipping and associated processes.
- Improving your time management techniques to get orders out faster.
Speed up payment processing to reduce accounts receivable days
Speeding up payment processing can bring your cash conversion cycle down considerably.
The right software can be a big help here, collecting and processing payments quickly and efficiently. The correct protocols will also help. For example, suppose your business doesn’t take charge immediately upon ordering. In that case, it can help to reduce the timeframe you require for this or to make your payment expectations clearer and more stringent.
Streamline and automate order fulfillment to expedite cash collection
If you can streamline and automate your order fulfillment process, it’s well worth doing. Speedier fulfillment means speedier payment, which reduces your CCC.
Order fulfillment software for small businesses can be a worthwhile investment, as it streamlines your entire quote-to-cash process, boosts order accuracy, automates things like shipping notifications, and alerts you of issues with orders, payments, etc.
Improve credit policies for quicker turnover of accounts receivable
Offering credit can improve your sales, especially if you offer higher-cost items; it can also leave you vulnerable to slow payment of accounts receivable.
If your cash conversion cycle could do with slimming down, it may be worth reviewing and improving your credit policies for a speedier turnaround.
Utilize technology for real-time tracking and inventory management
The right technology can streamline almost every element of your cash conversion cycle, and it’s beneficial for inventory tracking and management.
For example, good expense and time management software can help identify areas where you can cut inventory costs and improve your time management techniques. Optimizing turnover is often surprisingly simple when you understand where your time and resources are being wasted.
Similarly, inventory management tools and tracking software can do everything from tracking deliveries to sending out automated shipping notifications for customers.
Ergo, with the right software, you can thoroughly optimize your inventory processes and the inventory phase of your cash conversion cycle with them.
Proactively adjust inventory levels based on market trends
Being proactive about market trends can make a huge difference to your cash conversion cycle. To use a straightforward example, a fashion retailer will likely sell more winter clothing from October to February. This vendor will thus have a shorter CCC if they adjust their stock levels to carry more coats, jumpers, and so on during the colder months.
Market trends aren’t always as simple as this, of course, but if you’re savvy enough, you should be able to adjust your inventory in the best way for your audience.
Use the cash conversion cycle to optimize your eCommerce business
Cash conversion cycles have many moving parts, but it’s worth getting a solid handle on every aspect of yours.
Understanding your cash conversion cycle can help you do everything from speeding up your inventory turnover and boosting your cash flow to improving your vendor relationships and generally streamlining your supply chain.
All in all, understanding and keeping a close eye on your CCC is good for your business, your suppliers, and your customers. You can make cash conversion metrics part of your financial analysis process to get the rewards.
What is a cash conversion cycle?
A cash conversion cycle is the number of days a product takes from being delivered into a business’ inventory to being sold and paid for.
What is a good cash conversion?
Typically, a low or negative cash conversion value is considered good, but this depends greatly on the business model and values involved.
For example, real estate cash conversion cycles tend to be high due to the time it takes to sell a house, but the values involved are also high, so most realtors don’t consider this a problem.
How can you speed up the cash conversion cycle?
Several ways to speed up the cash conversion cycle include improving inventory management, cutting accounts receivable lead times, streamlining order fulfillment, and focusing on inventory turnover.