The cash conversion cycle measures the number of days between your date of payment for the goods and the date of receiving cash from customers. In simple words, it’s the time between cash going from the business and cash being received by the business.
On the other hand, the operating cycle measures the number of days between your date of buying inventory and the date your customer pays for the goods.
So, the effectiveness of the cash flow function is measured by both operating and cash cycles. Further, tracking a business’s operating and cash cycle over several years can be a valuable tool for assessing its financial health.
Sometimes, cash conversion and operating cycle are considered the same due to a little difference between these two concepts.
Comparative explanation of the concepts
An investment in inventory means that a company’s cash is bound until it sells the products. This means that whatever cash is locked up cannot be used for other purposes. As a result, maintaining cash and operating cycle as short as possible will benefit a company. Further, the businesses can also use this process to evaluate their management strategies and determine what areas need improvement.
Thus, managing these cycles can help the business manage inventory at the lowest cost possible, increase liquidity and minimize costs of the company’s operations.
Cash cycles are also known as cash conversion cycles or cash operating cycles that encompass the entire conversion process of converting a company’s assets into cash. As discussed above, the cash cycle calculates the amount of time spent on various production and sales processes from the date of paying cash to the date of receiving the cash. And this process is not completed before each dollar is credited to accounts receivable or invoices are paid in cash.
It’s important to note that the cash operating cycle begins when the business pays the cash and ends when it receives payment from its customers for that sales. By default, a company’s cash is unavailable for other purposes during the cash cycle. For instance, the business can not invest funds in the financing activities once it has paid the cash to acquire inventory.
So, the business desires to have a shorter cash cycle as the companies with the lower cash cycles are expected to have more reliable access to cash in hand and more opportunities to leverage that cash for business purposes.
Further, the length of the cash cycle varies from business to business. For instance, the construction sector is expected to have massive working capital requirements than the retail sector. Likewise, businesses with significant seasonal variations often find it difficult to maintain positive cash flow for a specific period of the year.
Cash Cycle components
The Cash Conversion Cycle depends upon three main components. And these play a crucial role in determining the cash cycle of the company. These are as follows.
- Days Inventory Outstanding (DIO)
- Days Sales Outstanding (DSO)
- Days Payables Outstanding (DPO)
Days Inventory Outstanding (DIO):
The DIO or Days Inventory Outstanding of an organization represents how much inventory is currently in the stores, or you can say in the company’s possession and how long it may take to sell that inventory ultimately.
Days Sales Outstanding (DSO):
DSO or Days Sales Outstanding is a measure that allows the company to know how long it takes to collect cash from sales and how much cash it generates in a given period. Further, the period can be taken as weeks, months, quarters, semi-annual, and annually.
Days Payables Outstanding (DPO):
In DPO or Days Payables Outstanding, a company indicates how much money it owes to its current suppliers or vendors and when it will pay that money to clear its obligations.
During an operating cycle, the company acquires raw material inventory, adds value, sells that inventory in the form of finished goods, and receives cash from customers. It’s important to note that the operating cycle begins when the business acquires inventory.
So, a variety of activities impact the operating cycle of the business. These activities include inventory processing time, finished goods holding time, and accounts receivables from customers.
Further, when a company operates on a shorter operating cycle, it keeps its cash for a shorter period in the business, which is generally more beneficial to cash flow and its overall benefit. It’s the same as in the case of the cash conversion cycle.
Interacting operating and cash conversion cycle
Even though each cycle serves a similar purpose, the operating cycle provides a complete insight into a company’s operating efficiency. The ultimate understanding of a company’s cash cycle will reveal how well it manages its cash flow. Additionally, in practice, it’s common for one cycle to have an impact on the other.
Cash cycles are expected to be shorter when an operating cycle is shorter and vice versa. Therefore, the analysis of both of these cycles is essential for the companies to perform both individually and jointly.
Differences between operating cycle and cash cycle
A company’s operating cycle and cash cycle are considered vital elements. And they both are known to provide you with the amount of time business takes to manage cash. However, they differ in other ways as well. An operating cycle differs from a cash cycle, and it is about how much time a business takes to operate its raw material to inventory, receivables, and cash.
On the other hand, the cash conversion cycle is about the management of the cash flow.
When a business converts inventory into cash, it is referred to as the operating cycle. And the cash cycle, on the other hand, accounts for the fact that a company does not have to pay its suppliers back immediately. They are both interconnected in their definitions.
However, the formula for calculating a company’s operating cycle is included in the cash cycle formula. To determine a business’s operating cycle, the inventory period must first be determined. An organization’s inventory holding period, or how extended inventory is stored before it is sold. To calculate an inventory period, use the following formula:
Number of days in a period / Inventory Turnover
This formula is used to calculate days for the inventory held on the floor of the business. A lower period of inventory is desirable from a business perspective, and however, it needs to ensure the availability of the inventory for the customers.
Accounts receivable period
Number of days in a period / Receivables Turnover
This formula helps to estimate the time business cash remain due from customers. Often businesses offer a cash discount on the early payment of receivables. Hence, the business needs to manage between the profitability and liquidity perspective.
The performance of these calculations enables the business to calculate the operating cycle as these are the components of the cash conversion cycle. The business can improve its operating cycle by increasing the efficiency of the value-adding process. Likewise, the higher efficiency of the business collection function can improve the ratio.
The operating cash flow can be prepared by adding inventory days and receivable days as given.
Operating cycle and cash conversion cycle
Inventory Period + Accounts Receivable Period
Similarly, operating cash flow can be converted into the cash conversion cycle by deducting the time business takes to pay their supplier. So, to improve the cash conversion cycle, the business can delay payments to the suppliers, leading to a shorter cash conversion cycle and higher business liquidity.
The formula for the cash conversion cycle is given below.
Cash Conversion Cycle = Days Inventory Outstanding (DIO) + Days Sales Outstanding (DSO) – Days Payables Outstanding (DPO)
The cash operating cycle is calculated to measure the performance of the business efficiency in terms of cash management. The business desires to maintain a shorter operating cycle as invested money in the business operations cost money in terms of opportunity cost/finance cost. Further, the business can improve its cash operating cycle by reducing the inventory holding period and enhancing the efficiency of the business collection function.
On the other hand, the cash conversion cycle is about the management of the cash. It considers all the factors that impact the cash, including time of holding inventory, collection of the receivables, and time is taken to pay off the cash to the suppliers. So, a payment factor to the suppliers is added in the calculation of the cash conversion cycle.
Frequently asked questions
What is the flow of the cash conversion cycle of the business?
Following is the flow of the cash operating cycle of the business.
- Receipt of the raw material in the business premises.
- Performance of activities to add value in the process.
- Selling of the goods to the business customers.
- Collection of the funds from suppliers.
- Deduction of payment made to the suppliers.
What’s the purpose of calculating the operating and cash conversion cycle.
The major difference lies in the purpose of calculation. The purpose of calculating the operating cycle is an assessment of the business efficiency in managing the operations. On the other hand, the purpose of the cash conversion cycle is to assess how fluently the cash flows in and out of business.
Why do businesses calculate the cash operating and cash conversion cycle?
The main purpose of calculating these cycles is an assessment of the liquidity, an in-depth understanding/analysis of the gaps in the process that stuck the funds in the business.