The cash operating cycle is the time taken by the business to realize its cash investment. In simple words, the business has to invest cash in purchasing the raw material, labor, overheads, and other business-related operations. However, it takes time for the business to realize cash, and holding of cash incurs finance expenses. Hence, businesses plan to shorten the operating cycle and realize cash.
The cash operating cycle can also be defined as:
‘’Time between which a business makes its payments to suppliers and receives cash from its debtors.”
Formula to calculate cash operating cycle
The following formula used for the calculation of the cash operating cycle:
|Inventory turnover days||XXX|
|Cash cycle/operating cycle/working capital cycle||XXX/(XXX)|
Sometimes, creditor days are eliminated from the formula to focus on internal business operations; the inclusion of the payable days makes it a cash conversion cycle. However, we have included payable days to better understand the mechanism of cash operations.
The shorter operating cycle is more desirable from a business point of view. It helps to enhance business liquidity status that leads to improvement in profitability. It can be even more welcoming if the cash operating cycle is negative in the above-given format. It will help the business generate free cash flow that can be invested in operating and financing activities.
So, it should be noted that liquidity or availability of cash is an equally relevant factor in determining whether the business should opt to expand its operations.
Explanation of the concept
The business must keep a check on its working capital ratios and cash operating cycle. The working capital cycle should not be unreasonable in length, i.e., there should be no over/under-investment in working capital as it can be risky in terms of effective business management.
The cash operating cycle shows a positive figure when there is a balance between incoming and outgoing payments. It decreases the net working capital and increases the free cash flows of a business.
For instance, if the business receives funds from its customers within 50 days and pays its suppliers within 30 days, its working capital cycle is calculated as 20 days. This 20-day cycle shows an adverse figure as the number of days debtors pay their dues is more than the creditor days. To maintain continuity of operations, a business needs to take funds from banks to continue its operations. The use of a bank operating line facility is associated with an interest expense that ultimately reduces a business’s profitability.
Free cash flow generation
Cash is the basic need to grow a business, and free cash can be achieved by shortening the cash operating cycle. The generation of cash by utilizing the shortened working capital tactic is the most efficient and inexpensive way to grow a business. Management can design policies and procedures to shorten its cash operating cycle.
It is evident from our discussion how important it is to maintain a shortened cash operating cycle. So, the business needs to consider different ways to enhance its profitability by improving the cash operating cycle.
How to improve a cash operating cycle?
If your business is trying to improve its cash operating cycle, here are certain ways by which you can achieve this goal.
Reduce extended payment terms to customers
Not allowing your customers extended payment terms is expected to reduce the free cash you need for business operations. In other words, quick payments from customers can significantly affect the cash cycle of a company. So, requesting a customer to make timely payments and timely billing can help to reduce the cash operating cycle.
Further, a discount offer to a customer can also help to receive timely payment. E.g., a 2/10 net 30 offer can convince a customer to make the immediate payment if he pays within the first ten days of purchase to gain a discount of 2% on the invoice value.
Companies can also reduce their cash cycle by setting specific credit terms for customers (like payments within 30 days). However, these credits terms restrictions require active follow-up with customers to make it effective.
Decide terms with your Suppliers/Creditors.
If your customers pay you on a timely basis, it will increase your cash in hand. However, if you immediately distribute this cash to your suppliers, the cash in hand will decrease. So, instead of making early payments to the suppliers, it’s advisable to reinvest this amount in business. Further, the creditors should make payments when they are due, as early payments to suppliers do not benefit a company. Although, it is beneficial to use the credit period provided by suppliers rather than making quick payments to them.
Efficient Inventory management
Inventory turnover days exhibit that how many days a business takes to sell its inventory. Further, it is necessary to sell the inventory quickly to improve the cash operating cycle. Just in time (JIT) inventory management systems focus on this feature as goods are only delivered under this system when needed.
In addition to the above, another useful way for efficient inventory management is to cut losses on slow-moving inventory by selling them at discounted prices. A business can free up the stuck cash that will ultimately improve the cash operating cycle.
Enhance cash flow management
Cash flow management is a process that keeps a record of the cash inflows and outflows of a business. Cash inflow means how cash is coming into a business. For example, cash sales, conversion of debtors into cash, financing facility from banks, sale of assets result in an increase of cash into a business. On the other hand, the cash used to make payments to suppliers and accounts payables reduces the cash in hand. Appropriate cash flow management policies and procedures help a business to shorten its cash conversion cycle.
Fix your operating processes
It’s important to measure how long your business takes to recover its investment in products and services. You need to go for a careful review at every step of your operations to understand which areas need more attention and whether it will result in achieving a great outcome or not. For this goal, take a hard look at each step and eliminate redundant steps to improve the cash operating cycle. For example, if the invoice preparation system is not efficient, it will lead to delayed payments from customers as it is not their fault that they have received invoices late. Such gap will ultimately lead to reduced cash in hand. To achieve efficiency, business needs to remove efficiency gaps out of the operational processes.
Adequately balance between profitability and liquidity.
It’s important to note that most startups do not fail because of the losses or less profitability but liquidity. So, the business should focus on the aspects of managing liquidity from the very first day.
For instance, allowing cash discounts to the customers can help to enhance the cash collection function. However, allowing discounts is an expense for the business. So, there is a need to balance between profitability and liquidity.
The balance can also be achieved by adjusting the original price in terms of managing business profitability.
The more cash a company holds in hand, the easier it is to meet its financial obligations. The company can reinvest these funds for the growth of a business. In this article, we have discussed different ways that can help a business to improve its cash operating cycle. The faster a company turns its inventory into sales, the quicker is the conversion of sales into cash occurs, and the better the cash flow is.
The methods to control/shorten the cash operating cycle include reduction of time allowed to the customers, extending time to pay for the supplies, effective inventory management, enhanced cash flow management, enhanced process efficiency, adequately managing between the liquidity and profitability perspective, and filling the gaps in the overall business processes.
It’s equally important to note that the business may not need to focus on all aspects of the operating cycle but specific components where gaps exist.
Frequently asked questions
Why is an analysis of the cash operating cycle important for the business?
Analysis helps to identify the gaps at different stages of the operating cycle. For instance, some businesses may have the problem of overstocking, leading to a higher cost of working capital. On the other hand, some of the businesses may have inefficient collection functions. Hence, this factor may be leading to a higher cost of capital.
What is the inventory management cycle break-up, and how is it linked with the cash operating cycle?
Following is the break-up of an inventory management cycle.
- Receipt of raw material from the supplier.
- Performance of value-adding services.
- Holding as finished goods to be sold
All these stages of the inventory holding require the use of the working capital, and there is a cost associated with it. Hence, the business must enhance process efficiency to handle inventory.
Which is a more important component for the cash operating cycle?
All components of the cash operating cycle are important. However, the business needs to identify the component which significantly contributes to the length of the operating cycle.