Reading: Activity Ratios

We can use the three preceeding activity ratios to assess the so-called Cash Conversion Cycle (CCC) of the firm. The CCC attempts to measure for how many days cash is tied up in the production and sales process before it is converted back to cash.

The CCC is typically calculated as follows:

where:

• DIO = Days inventory outstanding
• DSO = Days sales outstanding
• DPO = Days payables outstanding.

The interpretation is rather straightforward: 

• The cycle typically starts with a firm that purchases inventory on credit. Days payables outstanding (DPO) indicates how long the firm can wait, on average, to pay the bills for the purchase of that inventory. A larger DPO means that the firm can wait longer with the injection of cash in the production and sales process. DPO therefore shortens the cash conversion cycle.
   
• Days inventory outstanding (DIO) then indicates how many days it takes the firm, on average, to sell the inventory. The larger the DIO, the longer it takes a firm to convert inventory into sales. DIO therefore increases the length of the cash conversion cycle.
    
• Finally, sales typically do not result in immediate cash inflows. Days sales outstanding (DSO) indicates how long it takes, on average, for sales to convert into cash. Larger DSO thrfore also increases the lenght of the cash conversion cycle.

Remember from before, that we have computed the following activity ratios for Hershey in 2015:

• DPO = 43.6 days
• DSO = 29.6 days
• DIO = 70.2 days

Based on this information, the firm's cash conversion cycle is 56.2 days:

Therefore, it takes the firm 56.2 days, on average, to recover a dollar that is invested in the production and sales process.

In sum, the CCC is a helpful indicator of the liquidity risk that is associated with growth. As many firms have experienced, growth is often associated with significant cash needs. The CCC makes the time gap between cash paid to suppliers and cash received from customers more transparent.