Operating cycle and Cash Conversion Cycle
Operating cycle is the time taken between the purchase of supplies and the time when the cash is collected. It comprises of two parts: days inventory on hand and days sales outstanding. The day’s inventory on hand includes the work in progress, finished good manufacturing and the sales cycle. The day’s sales outstanding include the time between credit sales and the time taken to collect cash from the sales done on credit. So operating cycle is the count of days taken to convert cash to inventory to accounts receivable and cash.
(Needles etc, 2008) If the cash is occupied in accounts receivable and supplies/inventories, the organization will have low access to cash. This may hinder it from satisfying its short term requirements. So, Operating cycle= 365/Inventory Turnover + 365/Receivables Turnover. Cash conversion cycle, also known as the net operating cycle, on the other hand is the time duration between the times when the vendors are paid to when the cash is collected i. e. the time between payment for supplies and cash receipt for sales of these products.
Simple put, the cash conversion cycle is the time between when the cash is paid out to the time of receipt of cash. (CIMA,
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It goes through the manufacturing, packaging and delivering process. Then post delivering the invoice to the client, the last step is receipt of payment. So the shorter the cash conversion cycle the stronger the working capital management. With growing stress on just in time, there are companies which aspire towards a negative cash cycle. A larger organization with extensive manufacturing department would need more cash involved in inventories. Similarly if the customers take more time to pay the bills then the receivables increase.
Thus the net working capital can be lowered by managing the accounts payable and receivable. Both financial concepts help analyze the efficiency of the working capital management of an organization. An organization with a large cash conversion cycle is most likely to have cash flow issues. Say a company has bills due in recent future so it has cash flowing out, however the operating cycle is longer, so the cash coming in is longer, then the liquidity problems are likely to be high.
The basic difference between cash conversion cycle and the operating cycle is that while cash cycle refers to disbursing cash and collecting cash, operating cycle starts with owing cash to collecting cash. Hence cash cycle forms a part of the operating cycle. In a company with a shorter operating cycle the return on investment from the inventory it stocks is faster. Many industries mostly large businesses for example wineries and distilleries are found to have a longer operating cycle. Also operating cycle is calculated in terms of the duration the stock has to wait before sales, so it is not related to a definite accounting period.
Many businesses may think that investment in inventories is a good thing as it will eventually lead to returns. However there are many costs which are often neglected. For example the cost of maintenance such as handling cost, security cost, insurance etc. so inventory management is a very important concept that should be considered. In small business cash conversion cycle is considered to be key measure liquidity. It has been observed that larger organizations have a shorter cash cycle; however initiatives can be taken by smaller businesses to reduce their cash cycle.
By reducing the inventories kept in stock and applying concepts such as just in time, the case paid to acquire inventories can be reduced. Also by ensuring that the receivables are collected in time can have a positive effect on the working capital management. Cash conversion cycle also holds a positive relation with quick and current ratios, so the ratios should be maintained. Business consultants across the world have stated that cash cycles are the best measure for understanding a company’s health especially during its growth period.
John Costa from Outlook (Costa, 1997) says that while measures such as ratios can at times give misleading results, cash conversion ratio gives more accurate results. The inventory, vendor and credit policy change can only bring a change in cash cycle, since it is related to the asset turnover. So it is more dynamic and exact. Cash conversion cycle is found to be most effective in the retail industry whoever software, and consulting sector may not find the cash cycle analysis that effective. (Moss, Jimmy D, 1993)
If an organization wants to improve its cash cycle then they should consider four factors: the number of days client takes to pay the amount receivable by the company, the number of days it takes to manufacture/produce a product or deliver a service, the number of days the finished goods lies in the inventories till its sales, and the time the payment has to be made to the vendors. (Gattis, 2009) Once these factors are considered individually the organization can take measures to increase its efficiency. For example, special incentives or discounts may be given to the clients who make payments ahead of time.
Reference: CIMA (Chartered Institute of Management Accountants), June 2001, Business basic, Cash flow management, London, Chapter 1, page 2 Costa, John, Outlook, September 1997, “Challenging Growth: How to Keep Your Company’s Rapid Expansion on Track. ” Moss, Jimmy D. , and Bert Stine, December 1993, Managerial Finance, “Cash Conversion Cycle and Firm Size: A Study of Retail Firms. ” Gattis, G. Christopher, September 2009, The Cash Conversion Cycle, Blue Print Strategies. Needles E Belverd, Marian Powers, Crosson Susan, 2008, Financial and Managerial Accounting, page 289-291, George Hoffman, USA