Showing posts with label cash operating cycle. Show all posts
Showing posts with label cash operating cycle. Show all posts

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.
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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?
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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.

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.