GO TO MAIN PAGE COVERING ALL TOPICS ON CASH CONVERSION CYCLE/CASH OPERATING CYCLE. 

In the earlier article on the CCC, we learned about what is CCC, its components and the definition of each component. We shall now turn to how do we compute the various components.

To recap:

• Days Sales Outstanding or DSO represents number of days, the Accounts Receivable (AR) is outstanding in term of number of days of sales.

• Days Inventory Outstanding or DIO is then represents the number of days, the Inventory is outstanding in term of number of days of Cost of sales.

• Days Purchases Outstanding or DPO represents no of days, the ACCOUNTS PAYABLE is outstanding in term of number of days of Purchases

How then can we compute DSO, DIO or DPO?

1. DSO:-

As this represent the number of days the Accounts Receivable(AR) is outstanding in terms of number of days of sales, we should then count back actual sales each day until the AR is used up. This is called the exhaustion method. This method has the distinct advantage of using actual sales from the period covered by the debts and does not use average or annualized figures.

Suppose our AR at 31.8.05 totalled $3,400,000 we than look at most current August sales which say, has a figure of $2,300,000 (whole month consists of 31 days).

After deducting August sales figure of $2,300,00, what is left is $1,100,000

We then move on to the preceding month which is July’05 say July sales figure is $1,000,000 (whole month consists of 31 days)

What is left is $100,000.

Say June sales figure is $1,000,000(31 days) so $100,000 represents 100,000/1,000,000 x 30 days= 3 DSO

Therefore DSO=31(August)+31(July)+3(part of June)=65 days

So what does this mean? We can say that our August 05 AR are equivalent to all our sales for the last 65 days or we can say that our customers take an average of 65 days to pay or we can also say that whatever we sell tomorrow our customers will pay 65 days later.

Incidentally, this ratio is not affected by the sales value but rather by the payment terms and uncollected overdues and disputes. This is also a telling tale of how efficient our credit management department have fared in their handling of the AR, which includes overdues and disputes.

Similarly to compute DIO and DPO, we should use the above-said same methodology namely the exhaustion method of looking back at costs of goods sold/costs of sales and purchase respectively.

Below, is an example where we can effectively used CCC to our advantage.Within an umbrella of companies of similar business, we can tabulate their respective CCC to gauge their individual performance in managing working capital:-

The Finance Executive can then use this metric to look for a good model performer, perhaps studied their trends/method and apply to those which are weak in managing their CCC.

If you found this post useful, keep updated with future posts by subscribing to FMAccounting (for free) through RSS or email.

Related Entries

• Cash Conversion Cycle: An Overview
• Cash Conversion Cycle: An Illustration Besides Using The Exhaustion Method.
• Topics Covered In This Heading:Cash Conversion Cycle(CCC)/Daily Working Capital(DWC)Cash Operating Cycle
• Credit Management: Setting Up DSO Targets
• Using Days Inventory Outstanding (DIO) for Better Stock Management