Understand the Cash Operating Cycle

The cash operating cycle is the length of time between paying out cash for inputs and receiving cash from sales.  It is also referred to as the working capital cycle or  cash conversion cycle.

Businesses should understand, measure, control and finance their cash operating cycle.  It is also useful to be aware of the cash operating cycles of  customers, suppliers and even competitors.  The cash operating cycle is normally measured in days and is represented by the diagram below, using the example of a manufacturer.

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Time ------------------------->

Inventory of raw materials ---> @Cash paid out --> Conversion of raw materials --->  Inventory of finished materials ---> Receivables collection period ---> #Cash received

Supplier's payment period ---@Cash paid out --- CASH OPERATING CYCLE --- # Cash received

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Service Businesses
A consultancy working on long-term projects may have lots of money owed to them for 'unbilled work-in-progress' as well as long receivable collection periods.  Their main input cost will be consultants, who have no payment period.  A small consultancy business may have difficulty financing long cash operating cycles.  As such, it is common practice for consultancies to ask for stage payments from their clients on a long project.

Seasonal Businesses
Seasonal businesses, such as calendar and diary manufacturers have fluctuating operating cycles.  Production is spread throughout the year and inventories will gradually build up.  Trade receivables will increase from a low start as retailers stock up for the peak sales season, but may not pay until after the season.  The supplier's payment period will be negligible and therefore seasonal manufacturers will require several months of financing.

Retailers
A large retailer such as a supermarket will have a relatively low finished goods inventory period (due to perishables) and minimal receivables as the majority of their sales are in cash.  In addition, due to their size and purchasing power they can negotiate extended payment terms with suppliers.  Therefore, some supermarkets will actually have a negative cash operating cycle, in that they receive cash from customers before they have to pay suppliers.

The Ideal Cycle
Businesses should aim to minimize their cash operating cycles.

Know and try to minimize your cash operating cycle.