Please ensure Javascript is enabled for purposes of website accessibility

Foolish Fundamentals: Cash Conversion Cycle

By Motley Fool Staff - Updated Nov 16, 2016 at 12:57PM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

Profits don't mean much until they're converted to cash.

What do stores like Wal-Mart (NYSE:WMT), Home Depot (NYSE:HD), Target (NYSE:TGT), and Lowe's (NYSE:LOW) have in common? Their inventory needs must be massive. How do we go about analyzing their inventories as a measure of performance? By determining the company's cash conversion cycle and inventory turnover.

Although it would take some grade-A imbecility to get there, it's entirely possible under the accrual system in accounting for a company to go bankrupt while showing operating profits. Why? Because you can't pay your vendors with "profits"; you must pay them with cash. A company that does a poor job of bringing in cash, even if it's selling lots of stuff, should be avoided. Let's break this down by components.

1. Days inventories outstanding (DIO)
What we want to know is the number of days it takes for a company to "turn" its inventory. Let's use the fiscal 2005 annual results for Motley Fool Inside Value pick Home Depot.

Home Depot

($ in millions)

Cost of Goods Sold


COGS Per Day (annual COGS/365)






See how that works? Let's do the same thing with the other two components.

2. Days sales outstanding (DSO)
DSO is the amount of time it takes the company, on average, to receive money after it has sold a good or service.

Home Depot

($ in millions)



Revenues Per Day (annual revs/365)






3. Days payables outstanding (DPO)
Finally, we have to subtract from this total the number of days the companies hold onto cash after they pay for something. So we must also know the DPO.

Home Depot

($ in millions)

Cost of Goods Sold


COGS Per Day (annual COGS/365)


Accounts Payable




Now, to finally come up with the cash conversion cycle, you simply add the three numbers for DIO, DSO, and DPO. Be careful, though: DPO is a negative number.

Thus, Home Depot's cash conversion cycle is: 76 + 7 + (-43) = 40 days.

So, even with all of that inventory, Home Depot is still able to convert its own expenditures back into cash in only 40 days. That's astounding. You can also calculate these numbers on a quarterly basis (taking care to divide by 90 instead of 365) to have a more sensitive tool for determining the trend toward faster or slower cash conversion.

Cash conversion cycles don't translate well from industry to industry, so comparing companies that don't directly compete may not be helpful. Still, you can watch these cycles closely on a company-to-company basis, since they might warn of weakening business fundamentals that don't show up elsewhere.

Bill Mann, Shruti Basavaraj, and Adrian Rush contributed to this article.


Invest Smarter with The Motley Fool

Join Over 1 Million Premium Members Receiving…

  • New Stock Picks Each Month
  • Detailed Analysis of Companies
  • Model Portfolios
  • Live Streaming During Market Hours
  • And Much More
Get Started Now

Stocks Mentioned

Wal-Mart Stores, Inc. Stock Quote
Wal-Mart Stores, Inc.
$139.52 (0.11%) $0.15
Target Corporation Stock Quote
Target Corporation
$175.34 (-2.69%) $-4.85
The Home Depot, Inc. Stock Quote
The Home Depot, Inc.
$325.76 (-0.49%) $-1.62
Lowe's Companies, Inc. Stock Quote
Lowe's Companies, Inc.
$215.37 (0.58%) $1.25

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

Related Articles

Motley Fool Returns

Motley Fool Stock Advisor

Market-beating stocks from our award-winning analyst team.

Stock Advisor Returns
S&P 500 Returns

Calculated by average return of all stock recommendations since inception of the Stock Advisor service in February of 2002. Returns as of 08/18/2022.

Discounted offers are only available to new members. Stock Advisor list price is $199 per year.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.