One of the most important ways to understand the operating efficiency of any organization is to analyze its cash operating cycle and cash conversion cycle. These are two similar accounting concepts and they always go hand in hand. Financial experts, shareholders, and potential investors always look at these values for a company, because it provides a fair indication of how well it generates revenue from its production and businesses.
The concept of working capital also comes to the fore when we speak of these ratios. Net working capital is equal to current assets - current liabilities, and this provides an indication of how well the company can meet its short-term debts. Cash operating cycle, on the other hand, talks about the ability to convert raw materials and resources into cash through sales revenue.
It can be defined as the number of days that pass, on an average, between the time inventory is procured and the time when cash is received from its sale. It can also be defined as the number of days that pass by, between acquiring the raw materials for production, and selling the final product and receiving payment for it. Thus, it plays a very important role in the cash flow of a business.
If this cycle is long, it means that the company is taking too much time to convert production into sales proceeds. This reflects badly on the efficiency and financial management of the business, and necessary steps must then be taken to improve the performance. The formula is:
Operating cycle = Age of inventory + Collection period
Collection period is derived from the formula, (Number of days in a period x Accounts receivables) / Credit sales. Whereas, age of inventory is calculated as (Cost of inventory x Number of days in a period) / Cost of goods sold. All values are recorded in days for ease of calculation. Another way of calculating it is:
Operating Cycle = Outstanding inventory (in days) + Outstanding sales (in days) - Outstanding payables (in days)
When analysts scrutinize this ratio and compare it to industry standards or the competitors, it provides them a fair indication of the operating efficiency of the business. In all cases, a shorter cycle is preferred, as this implies that the business is converting raw materials into cash at a faster rate. So there is no piling up of liquidity, and the company is free to use the cash for more production, raw materials, and for investments. On the other hand, a longer cycle implies that too much stock is lying in inventory, and thus, reducing the company's liquidity. It also means that the business is taking too long to produce goods, and it needs to speed up its production process flow by removing waste and inefficiencies.
The terms of business credit that the company employs in dealing with buyers and suppliers is also important. If it buys too much of raw materials on credit, it will increase the operating cycle. When the business sells more goods on credit, it will take longer for it to receive payment from its debtors.
This ratio is also depicted in the company's financial reports, and it is one of the most important statistics for evaluating operating performance.