Cash Conversion Cycle
The cash conversion cycle is a measure of working capital efficiency, often giving valuable clues about the underlying health of a business. The cycle measures the average number of days that working capital is invested in the operating cycle. It starts by adding days inventory outstanding (DIO) to days sales outstanding (DSO). This is because a company “invests” its cash to acquire/build inventory, but does not collect cash until the inventory is sold and the accounts receivable are finally collected.
Receivables are essentially loans extended to customers that consume working capital; therefore, greater levels of DIO and DSO consume more working capital. However, days payable outstanding (DPO)–which essentially represent loans from vendors to the company–are subtracted to help offset working capital needs.
Circled in green are the accounts needed to calculate the cash conversion cycle. From the income statement, you need net sales and COGS. From the balance sheet, you need receivables, inventories, and payables. Below, we show the two-step calculation. First, we calculate the three turnover ratios: receivables turnover (sales/average receivables), inventory turnover (COGS/average inventory), and payables turnover (purchases/average payables). The turnover ratios divide into an average balance because the numerators (such as sales in the receivables turnover) are flow measures over the entire year.
Also, for payables turnover, some use COGS/average payables. That’s okay, but it’s slightly more accurate to divide average payables into purchases, which equals COGS plus the increase in inventory over the year (inventory at end of year minus inventory at beginning of the year). This is better because payables finance all of the operating dollars spent during the period (that is, they are credit extended to the company). And operating dollars, in addition to COGS, may be spent to increase inventory levels.
Taken From : Advanced Financial Statements Analysis