Let’s say you start a new business and buy inventory worth $80,000. During the first month, you sell all of that inventory for $100,000. This means your gross profit margin for the month was 20% ($20,000/$100,000). This is Scenario A.

Now, consider another Scenario B where in the first month, the $80,000 inventory got sold for $90,000 in 10 days. And then you buy another lot of $80,000 inventory and sell it again for $90,000 in 10 days. 10 more days left in this month, and you repeat this cycle once again: buy $80,000 inventory and sell it for $90,000. So, in the month, your sales were $270,000 ($90,000 x 3). Your inventory purchases for the month were $240,000 ($80,000 x 3). That means $30,000 in gross profit, which translates into a gross profit margin of 11.11% ($30,000/$270,000).

So, in Scenario A, the margin was 20% and in Scenario B, the margin fell to 11.11%.

And rightfully so, because in Scenario A, you sold $80,000 of inventory for $100,000 and in Scenario B, you sold the same inventory for a much lesser amount, i.e. $90,000.

But here’s where things get interesting: in Scenario A, the profit for the month was $20,000, whereas in Scenario B, the profit was $30,000. Why? Because in Scenario A, you rotated your inventory just once in the entire month. So, sales were just $100,000. Whereas in Scenario B, you rotated your inventory 3 times in the same month and hence sales were higher at $270,000. So, even if you took a smaller profit margin in Scenario B, more stock rotation and higher sales helped pull in more profit.

If we talk of ROI (return on investment) in your first month, it was 25% ($20,000/$80,000) in Scenario A, and a massive 37.50% ($30,000/$80,000) in Scenario B. This happened because in both cases your initial investment remains the same i.e. $80,000. But in Scenario B, you earned a higher profit of $30,000. Hence, a higher ROI in Scenario B.

What I’m trying to say is: profit margin doesn’t give the complete picture of how well a business is doing. A better metric is ROI.

Now, how to ensure a higher ROI in a business?

One of the best ways to do that is by improving the cash conversion cycle (CCC). The CCC is all about the velocity at which your cash tied up in inventory is converted into sales and then finally into cash once again.

Inventory -> Sales -> Cash.

But doesn’t sales mean cash? No, there are businesses that do credit sales and need to recover money from their customers in due time.

You measure CCC in days, and generally, a lower CCC means a higher ROI. Therefore, if you’re an investor, you’ll find companies with razor-thin profit margins giving great returns to investors.

Remember, profit margin is about efficiency at the transaction level. Whereas, ROI is all about velocity at the business level. The faster and often you recycle cash through the business, the higher will be the ROI.

So, how is CCC calculated? Simple. It’s:

CCC = Inventory Outstanding Days + Receivables Outstanding Days – Payables Outstanding Days.

Inventory Outstanding Days is how long inventories lie idle before being sold. It’s calculated by dividing average inventory (during a period) by COGS (cost of goods sold) and multiplying the result by 365. [(Average Inventory / COGS) x 365]

Receivables Outstanding Days is how long it takes to collect cash from customers after sales. It’s calculated by dividing average receivables during a period by credit sales and multiplying the result by 365. [(Average Receivables / Credit Sales) x 365]

Payables Outstanding Days is how long it takes to pay suppliers. It’s calculated by dividing average payables during a period by COGS and multiplying the result by 365. [(Average Payables / COGS) x 365]

For example,

Credit sales for the year = $400,000

Cost of goods sold (COGS) = $300,000

Inventory:

• Beginning of the year = $50,000
• End of the year = $70,000
• Average inventory = ($50,000 + $70,000) / 2 = $60,000
• Inventory outstanding days = ($60,000 / $300,000) x 365 = 73 days

Receivables:

• Beginning of the year = $40,000
• End of the year = $50,000
• Average receivables = ($40,000 + $50,000) / 2 = $45,000
• Receivables outstanding days = ($45,000 / $400,000) x 365 = 41 days

Payables:

• Beginning of the year = $30,000
• End of the year = $35,000
• Average payables = ($30,000 + $35,000) / 2 = $32,500
• Payables outstanding days = ($32,500 / $300,000) x 365 = 40 days

CCC here is 73 days + 41 days – 40 days = 74 days.

So, this business takes 74 days to convert cash invested in inventory into cash collected from customers after adjusting for time taken to pay suppliers.

Talking about the logic of how CCC is calculated, note that inventory and payables are recorded at cost; therefore, inventory and payables are divided by cost of goods sold (COGS). So, basically, when we divide average inventory or average payables by COGS, we’re calculating the fraction of the year those average inventory or average payables represent. Multiplying by 365 (since there are 365 days in a year) gives the outstanding in days. On the other hand, since we record receivables at the sale price, we need to divide them by credit sales.

Needless to say, the lower the CCC, the better ROI a business can expect. To lower CCC, a business should sell inventory faster, collect cash from its customers faster and take a longer time to pay its suppliers.

Is it possible for the cash conversion cycle to become negative? Yes, definitely. When you receive advances from customers and use that money to buy inventory from suppliers on credit.

This is how Dell achieved negative CCC in the 1990s. Dell sold its personal computers directly to its customers, unlike the traditional distribution or retail model. So, customers could directly place orders on the Dell website or through phone calls or through Dell’s retail stores. It may sound normal now, but back in those days it was revolutionary. Dell smartly didn’t manufacture a computer until it received an order from a customer. And an advance payment followed the order. Dell used the advance payment to order parts (on credit) and assemble a computer. Customers were also happy because their orders were “made-to-order”. What this did was reduce the inventory days and receivables days, and the payables days remained high. So, if you think about the formula we just discussed, negative CCC wasn’t surprising.

Having negative CCC means customers and suppliers funding your working capital.

Have questions? Comment below.