Benchmarking helps identify whether your cash conversion cycle aligns with industry norms or if there are areas where improvements can be made to match or surpass competitors. Analysing the cash conversion cycle, keeping track of bottlenecks, and benchmarking against industry standards are ways to identify areas for improving cash conversion. Companies should usually aim for a cash conversion ratio of 1–1.5, indicating they have sufficient funds to invest in growth opportunities. It is a liquidity indicator and shows how much money a company will have over the next 12 months.
What is cash flow conversion?
Generally, a lower CCC is considered a good cash conversion cycle, but the appropriate target CCC varies by industry. For example, retailers typically have a shorter CCC than manufacturers because they have a faster inventory turnover rate. In this blog post, we will cover the cash conversion cycle in detail, including its formula and calculation. We will also provide real-world examples of how the CCC is used in different industries, and strategies for improving your company’s CCC. A CCS of 1.0x means that $1 invested into the business yields $1 of topline recurring revenue. Let’s assume the average cloud company is receiving a 10x revenue multiple (about where we are at this writing).
- Instead, the takeaway is that the great companies can use the capital raised to catalyze growth.
- Neither revenue growth nor efficiency score would have indicated to an investor that the next round in the company, PagerDuty’s 2017 Series C at $750MM, would generate a ~90% IRR at its IPO close only 2 years later.
- A shorter cash conversion cycle is considered a good cash conversion cycle and indicates efficient management of receivables, inventory, and payables, which improves liquidity and operational performance.
- Originally founded by Bessemer Venture Partners, Cash Conversion Score (CCS) was created to provide a measure of return on invested capital for cloud businesses.
- For example, assuming that the average cloud company gets a 10x revenue multiple, the one dollar of revenue multiplied by the 10x multiple equals $10 of enterprise value.
To fully understand the formula and how it works, let’s take a look at each component. Before we can calculate our CCC, we need to find the values of our DIO, DSO, and DPO and plug them into our formula. Human Resources (HR) might feel like an afterthought for many small business owners juggling day-to-day demands, yet it has a… Small business owners often grapple with tax obligations that can swallow a large portion of their profits if not managed… Managing your business’s finances can often feel like juggling too many tasks at once, especially when you’re trying to keep… Moreover, by evaluating your business’s performance against competitors, you can identify loopholes and act accordingly.
Can a startup with a low cash conversion score still be successful?
If a company has a CCS of 1.0x, one dollar of investment into the business yields one dollar of topline recurring revenue. We realize that some might take this data to imply that raising incremental capital is bad, but that is not the takeaway at all. The median public cloud company raised $160MM to get to a ~$100MM revenue scale, with some companies having raised up to $750MM; it takes financing to build a market-leading company. Instead, the takeaway is that the great companies can use the capital raised to catalyze growth. They built their fantastic Cash Conversion Scores not by starving themselves of capital but rather through growing revenue alongside their capital base.
Focus on revenue quality
Dave Kellogg considered SaaS valuation in regards to literal “hype” around a company — the type of buzz that excites investors and pushes companies into unicorn and decacorn valuations. ROCE is more appropriate for gauging the profitability of public companies, as it’s not an accurate representation for companies with large, unused cash reserves (such as Seed Stage, Series A, and Series B companies). By looking at the Cash Conversion Score in concert with other metrics, we can see the full picture of a company’s health. To bring the numbers to life, the internal rate of returns for 0.1x-1.0x Cash Conversion Scores are shown below, assuming a constant 10x exit multiple and five-year hold on an investment. Once you’ve put your own figures through the Cash Conversion Cycle formula, you’ll have your company’s CCC.
Through comparing the hype ratio and Bessemer’s efficiency ratio, Sacks created the burn multiple (an inverse of Kellogg’s hype ratio). Throughout Bessemer’s history of investing in cloud computing, we’ve recommended that companies track their business’ progress using the five C’s of cloud finance. Here at Bessemer, we also use these metrics as internal guideposts when evaluating the performance of prospective, later-stage investments. After months of analyzing the data from the portfolio companies we have funded, we’ve identified the Cash Conversion Score as a new metric that is a signal for future success.
A practical example of a company’s CCC
Read our next blog in this series to learn What your Cash Conversion Cycle score means. Sunshine Apparel has an average inventory worth $50,000 and an annual cost of goods sold (COGS) of $365,000. For example, the operating cash flow of XYZ Co. was $2 million, and the net profit was $2.2 million. This is because they typically have to front the expenses before receiving any revenue, which can take weeks or even months. You want to compare efficiency across multiple time periods to create the full picture of efficiency across a sustained timeline.
How to visualize Cash Conversion Score?
Now that we have understood the formula and calculation for the cash conversion score cash conversion cycle, let’s dive deeper into why it’s important for your business and how it can impact your financial health. A high cash conversion ratio indicates that the company has excess cash flow compared to its net profit. For mature companies, it is common to see a high CCR because they tend to earn considerably high profits and have accumulated large amounts of cash. Generating $1 million in revenue with a $2 million burn is better than at $5 million burn. Craft Ventures founder and general partner David Sacks wanted a metric that would point toward capital efficiency in times of market downturn.
This metric showcases the incremental ARR dollars added for every dollar of burn, effectively measuring a company’s spending habits. Mature companies typically have a greater CCR since they generate considerably higher profits and accumulate huge cash. In contrast, start-ups usually have poor or even negative cash flows because of heavy capital investments. The cash conversion ratio (CCR) gives an overall picture of a company’s financial health. The HighRadius Order to Cash Suite automates credit management, collections, invoicing, cash application and dispute resolution, leading to faster revenue realization and improved cash flow. Designed to streamline workflows and enhance the customer journey, HighRadius’s O2C solutions drive financial performance, reducing DSO by an impressive 20%.
How to Take Your Capital Efficiency to the Next Level
- It begins with cash inflows from sales, investments, or financing, followed by outflows for expenses, investments, and debt repayment, influencing a company’s liquidity and financial health.
- Cash conversion metrics, such as cash conversion ratio and cash conversion cycle, assess how well a business manages its cash flow.
- Calculating these three components independently shows us where in the cash conversion cycle we can focus our attention and work to improve.
To find out more about how you can drive operational performance through benchmarks, contact us. A ratio between 0 to 1 suggests that the company’s profit conversion into cash is inefficient and needs to re-evaluate its operations. Efficient cash conversion ensures a company has enough cash to cover expenses, pay suppliers, and meet other needs. Discover how Yaskawa transformed its accounts receivable process, reducing bad debt and past-due payments with AR automation.
Unicorn valuations at x ARR multiples capture headlines while announcements of customers added and products launched often do not, leading to a flawed dynamic in which companies seek market validation by raising capital. The data, however, shows that CEOs are better served by only raising capital if and when that capital can generate a meaningful return, which often means not raising money. On the other hand, the cash conversion ratio measures how much cash flow a business makes compared to its accounting profit. Generally, a lower CCC is considered better as it indicates efficient management of working capital. However, the appropriate target CCC varies by industry, and businesses should aim to improve their CCC over time.
