The cash conversion cycle (CCC) is a metric that shows how long it takes for an organization to convert its resources into cash. In short, this metric shows how many days it takes to sell an item, get paid, and pay suppliers. When the CCC is negative, it means a company is generating short-term liquidity.
Aspect Explanation Concept The Cash Conversion Cycle (CCC) is a financial metric that measures the time it takes for a company to convert its investments in inventory and other resources into cash inflows. It reflects the efficiency of a company’s working capital management and provides insights into its liquidity and cash flow. The CCC is a vital tool for businesses to assess and optimize their operations, ensuring that they maintain sufficient liquidity while maximizing profitability. The CCC consists of three main components: the Days Inventory Outstanding (DIO), the Days Sales Outstanding (DSO), and the Days Payable Outstanding (DPO). The formula for calculating CCC is CCC = DIO + DSO – DPO. A shorter CCC typically indicates better working capital management. Key Components The Cash Conversion Cycle comprises the following key components:
– Days Inventory Outstanding (DIO): This represents the average number of days it takes for a company to sell its inventory. A lower DIO indicates faster inventory turnover, which can free up cash for other uses.
– Days Sales Outstanding (DSO): DSO measures the average number of days it takes for a company to collect payments from its customers after making sales. A lower DSO indicates quicker cash collection.
– Days Payable Outstanding (DPO): DPO represents the average number of days it takes for a company to pay its suppliers after receiving goods or services. A longer DPO means that the company can delay cash outflows, preserving cash for longer.
Application The Cash Conversion Cycle is widely used in financial analysis and management. It helps businesses assess the efficiency of their working capital management and identify areas for improvement. By optimizing the CCC, companies can reduce the need for external financing, minimize interest costs, and enhance their overall financial health. It also aids in evaluating the impact of operational changes and financial decisions on cash flow. Benefits The CCC offers several benefits to businesses:
– Liquidity Management: It provides insights into a company’s ability to meet short-term financial obligations and maintain adequate liquidity.
– Working Capital Optimization: Businesses can use the CCC to optimize their working capital, freeing up cash for investments or debt reduction.
– Identifying Inefficiencies: By monitoring the CCC, companies can identify bottlenecks and inefficiencies in their supply chain, inventory management, and credit policies.
Challenges Challenges associated with the CCC include:
– Complexity: Calculating and managing the CCC can be complex, especially for companies with extensive product lines, diverse customer bases, or global operations.
– Changing Industry Norms: Industry-specific norms and seasonality can affect the benchmark for what constitutes a favorable CCC.
– Data Accuracy: Accurate data on inventory turnover, accounts receivable, and accounts payable are essential for meaningful CCC calculations.
Real-World Application Businesses across various industries use the Cash Conversion Cycle to assess their financial health and make informed decisions. Retailers, manufacturers, and service providers, among others, can benefit from understanding and optimizing their CCC.
How does the cash conversion cycle work?
There are three aspects to take into account theconversion cycle:
- Days inventory outstanding
- Days sales outstanding
- Days payable outstanding
In other words, how long it takes for an item from when it sits in your inventory to when it is sold. How long it takes for you to the sale. And how much time you have to pay back suppliers.
Imagine you buy from an online store (just like ). You ordered an item and spent $50. You’ll get the item in 7 days. The online store has already collected the $50 and will ask the supplier to send it over to you within a week. But the store will pay the supplier only after 30 days. This means that now the store has $50 that can spend the next three weeks before the amount is due to the supplier. Those three extra weeks are crucial as the money could be spent to order other items and sell them with the same conversion cycle.
I want to show you how growth.uses a negative conversion cycle to generate extra to power up its business
|Days Inventory Outstanding (DIO)||DIO measures the average number of days it takes for a company to sell its inventory. It reflects the efficiency of inventory management.||– Lower DIO indicates faster inventory turnover, reducing the risk of holding obsolete inventory. – Higher DIO may tie up capital and increase storage costs. – Helps assess the efficiency of production and sales processes.||Example: A retail store with a DIO of 30 days means it takes, on average, one month to sell its inventory.|
|Days Sales Outstanding (DSO)||DSO measures the average number of days it takes for a company to collect payment from its customers after a sale. It reflects accounts receivable management.||– Lower DSO indicates faster cash collection, improving liquidity. – Higher DSO can strain cash flow and may signal issues with credit policies or collections. – Helps assess the effectiveness of credit and collection processes.||Example: A software company with a DSO of 45 days means it takes, on average, 45 days to collect payment from customers after a sale.|
|Days Payable Outstanding (DPO)||DPO measures the average number of days it takes for a company to pay its suppliers after receiving goods or services. It reflects accounts payable management.||– Higher DPO means the company can delay payments, preserving cash. – Lower DPO may strain cash flow and supplier relationships. – Helps assess negotiation power with suppliers and cash management practices.||Example: A manufacturing company with a DPO of 60 days means it takes, on average, two months to pay its suppliers after receiving goods or services.|
A better look at Amazon’s profitability
If you look at income statement, you’ll see that its operating income when it comes to the e-commerce side has been tight or harmful for most of its history. For instance, in 2022, as well, the losses from online stores generated an overall $2.7 billion loss for the company.
In short, the online stores dragged the whole company into a net loss. And yet, the online stores part is instrumental for the scale of Amazon, and it’s the underlying business unit that powers up the Amazon third-party stores, advertising, and subscription (Prime) segment.
Thus, there is a symbiotic relationship between Amazon’s online stores and these business segments (third-party stores, advertising, and Prime).
The part of the business that has high margins is related to Amazon AWS, and the interesting part is that Amazon AWS has become a business unit for its own sake, which could also work, as well, as a spun-off unit.
Instead, Amazon’s e-commerce platform, while it does have much better margins compared to the past, is still low compared to other parts of the business.
Yet, the company generates substantial cash from the operations.
Amazon’s continuous blitzscaling
So how does Amazon generate so much cash from operating activities?
The answer is in the cash conversion cycle, or the ability of Amazon to keep its operating margins low and yet generate short-term liquidity to keep expanding the business.
In fact, on the one side, Amazon has to make sure to keep its prices low, as this is part of its mission, and on the other side, through the cash conversion cycle, the company can still generate cash, unlocked to grow the operations.
This is a sort of business strategy driven by a financial model that drives the whole business. Thus, Amazon can keep its aggressive pricing strategy and yet still manage to continuously expand its operations.
Understanding Amazon’s financial model
A financial model, driven by cash conversion cycles, can be used for generating additional by efficiently managing three aspects:
- Days inventory outstanding (how long it takes before we sell that item we have sitting in the store?)
- Days sales outstanding (how long it takes to get paid by our customers?)
- Days payable outstanding (how much time we have before we are due to our suppliers?)
is quite successful in managing its conversion cycle.
In fact, as of 2017, gurufocus.com reported that had a conversion cycle of -26.92!
- Amazon.com Inc’s for the three months ended in Dec. 2017 was 19.87.
- Amazon.com Inc’s for the three months ended in Dec. 2017 was 35.27.
- Amazon.com Inc’s for the three months ended in Dec. 2017 was 82.06.
Therefore, Amazon.com Inc’s Cash Conversion Cycle (CCC) for the three months ended in Dec. 2017 was -26.92.
It practically means thathas almost thirty days before payments are due to its suppliers, while it has already generated available for the business by selling items in its online store!
But how and when does it make sense to operate a cash-generating business model? I believe there are four main aspects to take into account:
- Trust from customers
- Negotiating strength
First, you need to be Trusted by customers
Before could become so efficient in managing its conversion cycle business strategy, it took years to become trusted by its customers. Today Amazon.com is one of the most popular websites on earth, where each day billions of people purchased anything:
Data: Similar Web
Digitalization makes it easier
With digitalization, it has become easier for online stores to manage theirconversion cycle. For instance, think of the case in which you open up a store with a simple landing page. You don’t have anything down yet, but you start getting sales in.
Once an item gets pre-ordered, you can get it from a supplier and send it over to a final customer. In short, digitalization helps companies keep a more efficient inventory based on what customers order online even before they have it sitting in the inventories.
That is not an Amazon case. Amazon played the opposite business strategy: build giants super-organized inventories called Fulfillment Centers.
Fulfillment centers are the key to Amazon successful cash conversion cycle strategy
Amazon has been investing billions of dollars in automating and making more efficient its “fulfillment centers.” That, of course, helped the company to strengthen its conversion cycle:
Advantageous credits terms with suppliers
Another aspect is the company’s ability to negotiate convenient payment terms with its suppliers. If you’re able to stretch the payment agreement terms in a way that allows you to run your business on credit, it becomes easier to have excess growth. Just like has been doing in the last years.to invest in the business operations
Affiliate networks and programs
Another critical element of Amazon’s successful cash business strategy was built upon a network of publishers around the web, that in exchange for a referral to Amazon products could get a fee. This is the premise of affiliate marketing, on which Amazon has also built its fortune.
- The conversion cycle is a crucial aspect of any business in which success is based on short-term . When current assets minus current liabilities is positive, it means the company can generate extra from its operations.
- If well managed the conversion cycle can become a sort of making machine that generates additional for an organization.
- This is a sort of financial model that combined with a viable business model can unlock substantial growth for the business!
- Retail Industry:
- Technology Companies:
- Apple: Apple often has a negative cash conversion cycle as it collects payment from customers before paying its suppliers.
- Microsoft: Microsoft’s cash conversion cycle can vary, but it tends to be efficient due to its software licensing model.
- Automotive Industry:
- Toyota: Toyota has historically had a positive cash conversion cycle, primarily due to its Just-In-Time (JIT) inventory system, which minimizes inventory holding costs.
- Tesla: Tesla has managed to achieve a negative cash conversion cycle through tight control over its supply chain and customer pre-orders.
- Food and Beverage:
- Coca-Cola: Coca-Cola maintains a negative cash conversion cycle by quickly selling its beverages and delaying payments to suppliers.
- McDonald’s: McDonald’s operates with a negative cash conversion cycle by efficiently managing inventory and supplier relationships.
- Clothing Retailers:
- Zara: Zara, a fast-fashion retailer, has a negative cash conversion cycle by rapidly turning over inventory and minimizing holding costs.
- H&M: H&M also optimizes its cash conversion cycle by quickly selling fashionable clothing and managing supplier payments.
- General Electric (GE): GE’s cash conversion cycle can vary depending on its diverse business units, but it often strives for efficiency through supply chain management.
- Boeing: Boeing may have a positive cash conversion cycle due to the lengthy production cycles for commercial aircraft.
- Grocery Stores:
- Kroger: Kroger manages its cash conversion cycle efficiently by maintaining a balance between inventory turnover and supplier payments.
- Costco: Costco operates with a negative cash conversion cycle by selling memberships and paying suppliers on favorable terms.
- AT&T: AT&T’s cash conversion cycle can vary based on customer billing cycles and equipment sales.
- Verizon: Verizon manages its cash conversion cycle efficiently through billing practices and supplier relationships.
- Pfizer: Pfizer may have a positive cash conversion cycle due to the lengthy development and regulatory processes for pharmaceutical products.
- Johnson & Johnson: Johnson & Johnson balances its cash conversion cycle by managing inventory and supplier terms.
Key highlights of the cash conversion cycle and Amazon’s financial model:
- Cash Conversion Cycle (CCC): The metric that shows how long it takes for an organization to convert its resources into cash by considering Days Inventory Outstanding, Days Sales Outstanding, and Days Payable Outstanding.
- Amazon’s Operating Income: The e-commerce side of Amazon has had tight or harmful operating income for most of its history.
- Cash Generation: Despite the e-commerce side’s lower margins, Amazon generates substantial cash from its operations.
- Cash Conversion Cycle Strategy: Amazon’s ability to keep its operating margins low and use the cash conversion cycle to generate short-term liquidity allows it to continuously expand its business.
- Blitzscaling: Amazon’s continuous growth at a fast pace compared to competitors, prioritizing speed over efficiency.
- Managing Cash Conversion Cycle: Efficient management of inventory, sales, and payable days contributes to Amazon’s cash-generating business model.
- Fulfillment Centers: Amazon’s investment in automating and organizing fulfillment centers has strengthened its cash conversion cycle.
- Negotiating Strength: Amazon’s ability to negotiate favorable payment terms with suppliers contributes to its cash generation.
- Digitalization: The digitalization of online stores makes it easier to manage cash conversion cycles efficiently.
- Affiliate Marketing: Amazon’s network of publishers through affiliate marketing has further boosted its cash generation.
- Trust and Customer Base: Building trust with customers and having a large and loyal customer base are crucial for an efficient cash conversion cycle.
- Financial Model and Business Strategy: The combination of a financial model driven by the cash conversion cycle and a viable business model has enabled Amazon’s success and growth in various industries.
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