Operating cycle for a firm is the average time it takes from the receipt of raw materials for production to collection of cash from the sale of finished goods (Megginson & Smart, 2008). On the other hand, cash conversion cycle for a firm is the average time it takes from the payment to suppliers of raw materials to the collection of cash from the sale of finished goods. The difference between the two emanates from credit trade agreements between a firm and its suppliers such that the firm pays for the raw materials received at a later date. The difference between operating cycle and cash conversion cycle is simply the duration for which creditors or suppliers are willing to extend credit to the firm.
Cash conversion cycle = operating cycle – number of days of payables
As a business owner, operating cycle would be more important to me than a cash conversion cycle. It is important for the owner of the business to know the level of current assets required for the operations of the business. Operating cycle helps in determining a firm’s current asset needs. A shorter operating cycle implies a firm can operate effectively with a small amount of current assets. It is also an indication of whether a firm is managing inventory and receivables effectively as well as the liquidity of the firm. A shorter operating cycle indicates that a firm is efficient in managing its inventory and receivable and that its liquidity is high. On the other hand, using cash conversion cycle to determine if a firm is effective in its cash management can be misleading. A shorter cash conversion cycle can imply efficient management of cash or mismanagement. For instance, a firm may have a shorter cash conversion cycle by paying its accounts payable after the expiry of the credit period. Even though this reduces the length of the cash conversion cycle, it is a poor financing decision as it leads to large balances of accounts payable. Cash conversion cycle can therefore be misleading hence as a business owner, operating cycle would be more important to me.
References
Smart, S. B., & Megginson, W. L. (2008). Corporate finance. Mason, Ohio: Thomson/South-Western.
