Operating and Cash Conversion Cycles

A company’s number of days of payables, number of days of receivables, and number of days of inventory may be combined to indicate its operating cycle and net operating cycle.

The operating cycle and net operating cycle are two measures which help to evaluate how effective a company is in generating cash from the sale of inventory. A company which is able to generate cash in a timely manner will have less need for external financing.

Evaluating Working Capital Effectiveness

Operating cycle

The time that a company needs to convert its raw materials into cash from sales is known as its operating cycle.

In the form of an equation,

Operating cycle = No. of days of inventory + No. of days of receivables

Net operating cycle

A company can increase the cash that it has available by deferring the payments that it makes to its suppliers. This deferral is taken into consideration in determining the company’s net operating cycle, otherwise referred to as its cash conversion cycle.

The net operating cycle measures the time from a company pays its suppliers for raw materials to the time it collects cash from the subsequent sale of the goods produced from these supplies.

In the form of an equation,

Net operating cycle = Operating cycle – No. of days of payables

Or

Net operating cycle = No. of days of inventory + No. of days of receivables – No. of days of payables

Peer Company Comparison – Working Capital Effectiveness

The shorter a company’s operating cycle and cash conversion cycle, the greater is its cash-generating ability and the less need it has for liquid assets or external financing. Therefore, a company which has a shorter operating cycle or cash conversion cycle relative to its peers is said to have a more effective management of its working capital than its peers.

Question

You have been provided the following financial data about a firm:

$$ \begin{array}{l|r} \text{Credit sales} & {15,000} \\ \hline \text{Cost of goods sold} & {12,000} \\ \hline \text{Accounts receivable} & {1,800} \\ \hline {\text{Inventory } – \text{ Beginning balance}} & {1,650} \\ \hline {\text{Inventory } – \text { Ending balance}} & {1,400} \\ \hline {\text{Inventory } – \text { Average inventory}} & {1,525} \\ \hline \text{Accounts payable} & {1,200} \\ \end{array} $$

The operating cycle for this company is closest to:

A. 90.17 days.

B. 74.521 days.

C. 102.698 days.

Solution

The correct answer is A.

Operating cycle = No. of days of inventory + No. of days of receivables.

Average Inventory = (1,650 + 1,400/2) = 1,525

No. of days of inventory = 1,525/(12,000/365) = 46.37 days

No. of days of receivables = 1,800/(15,000/365) = 43.8 days

Therefore, Operating cycle = 46.37 days + 43.8 days = 90.17 days

Reading 35 LOS 35c:

Evaluate working capital effectiveness of a company based on its operating and cash conversion cycles and compare the company’s effectiveness with that of peer companies