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.
- 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?
- 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.
- a business with 20 inventory days and 80 receivable days cannot be compared to
- a business with 80 inventory days and 20 receivable days.