What is the difference between the firm’s operating cycle and its cash conversion cycle?
Working capital management involves ensuring positive cash flows so that investors required return is achieved. Thus, the value of a firm increases when the required investment in working capital is reduced (Sagner, 2010). Businesses that seek to expand their operations need to monitor their operating and cash cycles. The importance of monitoring cash and operating cycle is to assist businesses to balance the cash invested and returns expected to be received. For companies to remain financially independent and be successful they should obtain the balances. Money is used by businesses to purchase inventory and unless the inventory is sold, the money is tied up and it cannot be used for other business operations. Maintaining cash conversion cycle and short term operating cycle helps businesses to reduce depreciation costs and inventory storage and to keep a high liquidity.
An operating cycle is defined as the average time taken to acquire inventory and get receipt from its sale. If the operating cycle is short, this implies that return on inventory investment by the firm is received promptly. When a company is facing financial distress cause by different issue such as lawsuits, the operating cycle appears to be longer meaning that cash does not move quickly. Consequently, a firm would need more working capital to enable it to continue with its operations (Sagner, 2010). Most firms acquire inventory on credit, which enables them to reduce the operating cycle. However, allowing customers to pay for goods they purchase later than the date of purchase increases the operating cycle. On the other hand, cash conversion cycle (CCC) is the number of days that a firm needs to obtain cash flows from its resources. This measure explains the time a company takes to convert each dollar input in the production process when it is received in the form of return. The CCC is essential because it gives a better view of a firm’s financial stability (Baker, & Powell, 2009). This is because it express the time in which money is tied up in assets for purposes of business process and it cannot be invested to achieve high returns.
Although both the operating cycle and cash conversion cycle ae used by investors to measure business wealth in term of the money that flows in to the operation, the two measure have various differentiating aspects. The two measure different aspects of the cash flow ad provide investors with different information that is useful to investors. The following aspects can be used to differentiate between operating cycle and cash conversion cycle
Measurements and Calculations
The operating cycle measures the time between the purchase of inventory and receipt of cash for its sale. The CCC measure the time take between cash payout in form of expenses and the time cash is received back to the business in form of return (Baker, & Powell, 2009).
Operating Cycle = 365 × Average Inventories + 365 × Average Accounts Receivable
Purchases Credit Sales
CCC = Inventory days outstanding + Days payable outstanding + Days sales outstanding
Overlap
The two measures overlap by necessity with the cash cycle measuring longer period since the time material are purchased for processing, converted into inventory, until they are sold. However, operating cycle only measures the time when finished goods enter the business warehouse as inventory until when they are sold.
Uses
The operating cycle provides information to investors relating to the time it takes for inventory to be sold. Contrastingly, the cash cycle explains the profitability of a business. The cash cycle can be used as financial ration and profitability indicator. When preparing financial statement, businesses can use the cash cycle to measure the frequency of obtaining cash flow. Additionally, the cash cycle also helps to compare how much money a company spends as expense and how much it receives in form of cash flow (Baker, & Powell, 2009).
Interactions
The operating cycle and cash cycle influence each other. If it takes longer for a business to convert raw material into finished goods then the inventory would take long time to be sold. If the operating cycle is longer, the firm might take long to purchase raw material needed to manufacture finished goods increasing the cash cycle.
Working Capital
The operating cycle requires funding to be able to have inventory that can be sold. This is different with cash conversion cycle because suppliers can offer the business with goods on credit and later pay them after they have been sold as finished goods (Sagner, 2010).
Which would be more important to you as an owner and why?
For a business owner, these measures are very important because they give different information that is important in decision-making. Even so, the cash conversion cycle is very important because it provides information relating to the profitability of a business (Leach, & Melicher, 2014). Further, the operating cycle can be obtained from the cash cycle. The cash cycle can also be viewed as the net operating cycle because it essentially gives a business owner information about how much money is tied up in assets, making an informed decision on whether to acquire additional capital or not. By computing the cash conversion cycle, a business owner can tell whether his or her business can sustain its operation and continues as going concern. Therefore, it is recommendable that business owners and investors compute the CCC to see the financial strength of a business
References
Baker, K., & Powell, G. (2009). Understanding Financial Management: A Practical Guide. New Jersey: John Wiley & Sons.
Leach, C., & Melicher, R. (2014). Entrepreneurial Finance. Boston, MA: Cengage Learning.
Sagner, J. (2010). Essentials of Working Capital Management. New Jersey: John Wiley & Sons.
