Cash conversion cycle is calculated as the sum of average inventory days and average receivables collection days minus average payables payment period for the financial year. The ratio, expressed in number of days, helps understand the length of time it takes to convert raw material into inventory, sell the inventory, collect cash from debtors and pay off creditors who supplied raw materials.
For example if the company takes 28 days to manufacture the product and sell it on credit, 13 days to collect from debt holders and has 32 days time to pay of its creditors – cash conversion cycle is 28+13-32 i.e 9 days.
Cash conversion cycle indicates how efficiently the company is using short-term assets and liabilities to generate cash. The lower the number of days, the more efficient the company is in converting raw material into finished products, selling the same and collecting cash.