Tuesday, 20 April 2010

Measure the cash operating cycle

Let us examine the method used to measure the length of the cash operating cycle.  This is used to assess a business's cash needs and any financing requirement.

Measuring the cycle

The following formulae can be used to measure the length of the cash operating cycle for a manufacturing business.  The length is usually measured in days, although weeks or months can easily be calculated too.

a.  Raw materials holding period
= (average raw materials inventory / annual raw material usage) x 365 days

b.  Materials conversion period
= (average work in progress inventory / annual cost of sales) x 365 days

c.  Finished goods inventory period 
= (average finished goods inventory / annual cost of sales) x 365 days

d.  Receivables collection period
= (average receivables / annual sales) x 365 days

e.  Supplier's payment period
= (average trade payables / annual purchases) x 365 days

Length of Cash operating cycle length 
= a + b + c + d - e

The following should also be considered:

  • Business growth, which will affect the cycle in the future, and 
  • Seasonality, which will affect the cycle at different times of the year.

Think about the cash operating cycle of your business in comparison with that of your suppliers and customers.  
  • Who has the greatest exposure to cash flow problems?
  • How much room to manouevre do you have if your cycle slows down?
  • Do you need extra finance?

Financing the cycle

The length of the working capital cycle will help indicate how much working capital is required by the business and therefore how much needs to be financed.  For most businesses there will be a proportion of their working capital requirement which is constant and a proportion which is variable.

  • It is advisable to fund the constant stable part with medium to long-term finance.  
  • For the variable requirement, short-term flexible finance such as an overdraft is more suitable.

The value of investment required will increase over the cycle.  For example, 
  • a business with 20 inventory days and 80 receivable days cannot be compared to 
  • a business with 80 inventory days and 20 receivable days.  
Although both have 100 days' requirement, the investment required in the first business is far higher, as the value of receivables (sales price) is more than the value of inventory (cost).

The cash operating cycle length should be measured to determine the working capital financing requirements.

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