Cash Operating Cycle

One of the most important ways to understand the working efficiency of any business organization, is to analyze its cash operating cycle and the cash conversion cycle. These are two similar accounting concepts, and they always go hand in hand. Financial experts, shareholders and potential investors always look at these values for a company because it gives a fair indication of how well the company generates revenue from its production and businesses.

The concept of working capital also comes to the fore when we speak of these cash cycles. Net working capital formula tells us that it is equal to current assets - current liabilities, and this gives an indication of how well the company can meet its short term debts and liabilities. Cash operating cycle, on the other hand, talks about the ability to convert raw materials and resources into liquid cash.

Cash Operating Cycle Definition

Let us now see what is cash operating cycle exactly. It can be defined as the number of days that pass, on an average, between the time inventory is acquired by the business and the time when cold hard cash is received from the sale of this inventory. It can also be defined as the number of days that pass by, between acquiring the raw materials for production, and selling the final product and receiving payment for it. Thus this plays a very important role in the cash flow of the business.

Hence, if the operating cycle is long, it means that the company is taking too long to convert production processes into sales proceeds. This reflects badly on the efficiency and the financial management of the business, and necessary steps must then be taken to improve this performance. Cash operating cycle formula is as follows.

Operating Cycle = Age of Inventory + Collection Period

In this scenario, collection period refers to the formula 365 / Receivables Turnover, and accounts receivable turnover refers to Account Receivables / Sales or Turnover. Age of inventory refers to 365 / Inventory Turnover, and Inventory Turnover is calculated as Inventory / Cost of Sales. Both the values are recorded in days, and operating cycle is also represented as days for ease of calculations. Another way of calculating cash operating cycle is as follows.

Operating Cycle = (Number of days the inventory is outstanding) + (Number of days the sales are outstanding) - (Number of days payable amounts are outstanding)

When analysts scrutinize the cash operating cycle of a business and then, compare the figures to industry standards and rivals figures, it gives them a fair indication of the operating efficiency of the business under microscope. In all cases, a short operating cycle is preferred, since this implies that the business is converting raw materials into cash at a faster rate. So there is no piling up of liquidity, and the company is free to use the cash for more production, more raw materials and for investment purposes. On the other hand, a long operating cycle implies that too much stock is lying in inventory and thus reducing the company's liquidity. It also means that the company is taking too long in its production process, and it needs to speed up the all its sales and production activities.

The terms of business credit that the company employs in dealing with buyers and sellers is also important. If a company buys too many raw materials on credit then it counts as accounts payable, and an increase in this figure will increase the operating cycle as well. When the business sells its goods on credit, it will take longer for the business to receive hard cash from debtors. Thus, cash operating cycle refers to the period between paying and receiving cash outlays physically.

The cash operating cycle ratio is also depicted in the company's financial accounts, and it is one of the most important efficiency ratios that are open for cash flow analysis and scrutinization. These are a bunch of ratios that help a number of parties determine the health of a company, and its importance cannot be undervalued at any stage. Every company must strive to reduce the number of days in cash operating cycle so that their efficiency increases, so that they have more liquid cash to meet obligations and so that the public and analysts view them as a healthy and efficient company.