# The cash conversion cycle

> How DSO, DIO and DPO combine into the cash conversion cycle, why distributors fund the gap before customers pay and what early-pay discounts cost.

Source: https://docs.lumina-erp.com/distribution/cash-conversion-cycle/

**In short.** The cash conversion cycle is days sales outstanding plus days inventory outstanding minus days payable outstanding: the number of days your cash is tied up between paying a supplier and collecting from a customer. Measure all three on the same period and averaging method, and remember that a 2/10 net 30 discount is worth about 37% a year, so passing it up to stretch payables is rarely cheap.

A distributor pays for goods, holds them, sells them on credit and then waits to be paid. The cash conversion cycle (CCC) measures how many days the company's own money is tied up in that loop. It is built from three shorter measures: how long customers take to pay, how long inventory sits and how long you take to pay suppliers. Every day you take out of the cycle is cash you no longer have to borrow.

## At a glance

| Measure | Question it answers | Based on | Lower is |
|---|---|---|---|
| DSO, days sales outstanding | How long do customers take to pay? | Revenue | Better |
| DIO, days inventory outstanding | How long does inventory sit before it sells? | Cost of goods sold | Better, if service holds |
| DPO, days payable outstanding | How long do we take to pay suppliers? | Cost of goods sold | Worse (higher DPO shortens the cycle) |
| CCC | How many days is our cash tied up? | DSO + DIO minus DPO | Better |

## The three parts

### Days sales outstanding

DSO measures how many days of sales are sitting in accounts receivable.

**Days sales outstanding:** `Average accounts receivable ÷ revenue for the period × days in the period`

Use credit sales if you can separate them. Cash sales at a counter are collected on day zero and pull DSO down in a way that says nothing about your credit customers.

### Days inventory outstanding

DIO is the same number as days on hand on the [inventory turns page](/distribution/inventory-turns-and-gmroi/): how many days of cost of sales are held as inventory.

**Days inventory outstanding:** `Average inventory at cost ÷ cost of goods sold for the period × days in the period`

### Days payable outstanding

DPO measures how many days of purchases are sitting unpaid in accounts payable.

**Days payable outstanding:** `Average accounts payable ÷ cost of goods sold for the period × days in the period`

Strictly, payables relate to purchases, not COGS. Most people use COGS because it is on the income statement and, for a distributor with stable inventory, purchases and COGS are close. If inventory rose or fell sharply in the period, purchases (COGS plus the change in inventory) is the better base.

### The cycle

**Cash conversion cycle:** `DSO + DIO − DPO`

The first two terms are how long cash is out. The last is how long suppliers are, in effect, financing you.

## Worked example

With invented round numbers that match the calculator's starting values, one year looks like this.

| Input | Amount |
|---|---|
| Revenue | $16,000,000 |
| Cost of goods sold | $12,000,000 |
| Average accounts receivable | $2,000,000 |
| Average inventory at cost | $2,400,000 |
| Average accounts payable | $1,300,000 |

- DSO: $2,000,000 ÷ $16,000,000 × 365 = **45.6 days**
- DIO: $2,400,000 ÷ $12,000,000 × 365 = **73.0 days**
- DPO: $1,300,000 ÷ $12,000,000 × 365 = **39.5 days**
- CCC: 45.6 + 73.0 minus 39.5 = **79.1 days**

For about 79 days, this business has paid for goods it has not yet been paid for. One day of DSO is worth about $43,800 of cash (revenue ÷ 365), and one day of DIO or DPO is worth about $32,900 (COGS ÷ 365).

_Interactive calculator available on the web page._

## How the cycle plays out in distribution

### You pay before you collect

A typical distributor buys on net 30 terms, holds stock for weeks or months and sells on net 30 or longer. Even when customer and supplier terms match on paper, inventory time sits between them. This is what makes distribution working-capital heavy. In the example above, the business needs to fund 79 days of activity before a dollar comes back.

### Growth consumes cash

Because receivables and inventory scale with sales, growth raises the amount tied up even if the number of days stays the same. A distributor growing 20% a year with a steady 79-day cycle needs roughly 20% more working capital each year. Profitable, fast-growing distributors run short of cash for exactly this reason.

### The three levers pull against each other

Each lever frees cash and carries its own risk.

| Lever | Shortens the cycle by | Watch for |
|---|---|---|
| Collect faster (lower DSO) | Tighter credit, prompt invoicing, active collections | Lost customers who expect terms |
| Hold less stock (lower DIO) | Better reorder points, clearing dead stock | Lower fill rate and lost orders |
| Pay later (higher DPO) | Negotiating longer supplier terms | Lost early-pay discounts, strained suppliers |

The last lever is the one most often pulled badly.

## What early-pay discounts cost

Supplier terms such as **2/10 net 30** mean: take 2% off if you pay within 10 days, otherwise pay the full amount by day 30. Passing up the discount lets you keep the money for 20 more days at a cost of 2% of the invoice, which makes it expensive borrowing.

**Annualized cost of passing up a discount:** `Discount % ÷ (100% − discount %) × 365 ÷ (net days − discount days)`

For 2/10 net 30:

- 2 ÷ 98 = 2.04% for 20 days of credit
- 2.04% × 365 ÷ 20 = **37.2% a year** (simple rate)
- Compounded over the year: (1 + 2 ÷ 98) raised to the power 365 ÷ 20, minus 1 = **44.6% a year**

For 1/10 net 30 the same arithmetic gives 18.4% simple and 20.1% compounded.

_Interactive calculator available on the web page._

Unless you can find no cheaper source of cash, taking the discount almost always wins. In the invented example, paying every supplier on day 10 instead of day 30 would need about $657,500 more cash ($12,000,000 ÷ 365 × 20). If every purchase carried 2/10 net 30 terms, the discounts earned would be about $240,000 a year, far more than the interest on $657,500 at any ordinary borrowing rate.

:::note[Discounts shorten DPO on purpose]
Taking early-pay discounts lowers DPO and lengthens the cash conversion cycle. That is a good trade when the discount rate is higher than your cost of funds. Do not judge purchasing by DPO alone. Report discounts taken and missed next to it.
:::

## Common measurement mistakes

### Mixing periods

DSO on last quarter's revenue, DIO on a trailing year and DPO on this month's payables do not add up to a real cycle. Use the same period for all three, and scale days to match (90 or 91 for a quarter, 365 for a year).

### Using year-end balances only

Distributors often clean up at year end: collections push, inventory written down or counted, payables paid before the books close. Year-end balances then describe the best day of the year, not a typical one. Use an average of month-end balances.

### Using revenue for DIO or DPO

Inventory and payables are carried at cost, so divide them by cost of goods sold. In the example, dividing inventory by revenue would give 54.8 days of DIO instead of 73.0, making the cycle look 18 days shorter than it is.

### Leaving out what does not fit

Customer deposits, unbilled shipments, supplier rebates receivable and consigned stock all affect cash timing. Decide whether each belongs in the calculation, and apply that choice every period.

### Comparing businesses with different models

A distributor that drop-ships a large share of sales holds less inventory than one that stocks everything, so its DIO is naturally lower. Compare against your own trend and against businesses with the same stocking model.

## Freeing cash from the cycle

1. Pull average AR, inventory at cost and AP for the same 12 months from your ERP, using month-end balances. These numbers come straight from the receivables, inventory and payables ledgers.
2. Calculate DSO, DIO, DPO and the cycle, and put the dollar value of one day next to each.
3. Pick the lever with the most cash per day and the least customer risk. For most distributors that is slow and dead inventory, then overdue receivables.
4. Report early-pay discounts taken and missed alongside DPO, so nobody stretches payables at 37% a year to improve a ratio.

For the inventory side of the cycle in more detail, see [Inventory turns, days on hand and GMROI](/distribution/inventory-turns-and-gmroi/).

## Sources

- [A Beginners' Guide to Financial Statements (U.S. Securities and Exchange Commission)](https://www.sec.gov/about/reports-publications/beginners-guide-financial-statements)
- [Cash Conversion Cycle (Corporate Finance Institute)](https://corporatefinanceinstitute.com/resources/accounting/cash-conversion-cycle/)

---

Epicor, Prophet 21, P21 and DynaChange are trademarks or registered trademarks of Epicor Software Corporation registered in the United States and other countries. Kinetic is a trademark of Epicor Software Corporation. Lumina ERP is an independent consultancy and is not affiliated with, sponsored by or endorsed by Epicor.