What is the Cash Cycle?

The cash cycle or also known as the Cash Conversion Cycle, Net Operating Cycle or Cycle Cash, measures the time it takes for a company's investments to translate into sales and income. This metric represents the time it takes to move inventory, collect, and pay off debt without incurring additional fees or interest. The cash cycle is generally measured in days.

The cash cycle is one of the ways that companies and stakeholders can objectively measure the quality and effectiveness of operations and management. Because increasing efficiency and reducing production costs is always desirable to increase margins of profit, most companies constantly try to decrease or maintain their cash cycle relative to the weather.

However, not all companies use this metric. The cash cycle is most useful for industries that rely on physical inventories. Retail companies are a common example of a type of company that would derive a lot of meaning from the cash cycle metric.

Cash Cycle Characteristics

The cash cycle measures how many days it takes for a business to receive cash from a customer from its initial cash outlay for inventory. For example, a typical retailer purchases inventory on credit from its suppliers. When inventory is purchased, an account payable is established, but the cash is not actually paid for some time.

Payment is paid within 30 days and inventory is marketed to customers and ultimately sold to a customer on account. The customer then pays for the inventory within 30 days of purchase.

The cash cycle measures the number of days between the payment to the vendor for inventory and the time the retailer receives the cash from the customer.

As with most cash cycle calculations, smaller or shorter calculations are almost always good. A short conversion cycle means that a company's money is tied up in inventory for less time. In other words, a business with a small conversion cycle can buy inventory, sell it, and receive cash from customers in less time.

In this way, the cash conversion cycle can be viewed as a sales efficiency calculation. It shows how quickly and efficiently a business can buy, sell, and collect from its inventory.

Formula to calculate the cash cycle

Calculating the cash cycle can be a bit overwhelming at first, but once the elements within the calculation are understood, it is easy.

Reference should be made to the financial statements, including: the balance sheet and the income statement. This provides information for calculations.

The formula for the cash conversion cycle is made up of three elements as we mentioned earlier. Among them: days pending inventory, days pending sale and days pending payment. Namely:

Cash cycle (CC) = days of pending inventory (DIP) + days of pending sales (DVP) - days of pending payment (DPP)

To find the numbers needed to use the cash cycle formula, you need to extract multiple data points from the company's financial statements, including:

• The set number of days or time period that is being measured.
• Total revenue and cost of goods sold within a given time.
• The total inventory at the beginning and end of a given time.
• How many accounts receivable does the company have at the beginning and end of a given time.
• How much the company owes at the beginning and end of a given moment.

All of these items are typically found in a standard financial statement.

Example

To better understand how the cash cycle is calculated, let's use an example as our guide. The following metrics are measured in millions of dollars.

Suppose a company wants to calculate its cash cycle for fiscal year 2019 and compare it to its numbers for fiscal year 2018. They would first begin by gathering the numbers needed to complete the formula. Let's say these are the numbers collected from your financial statements:

Numbers	Fiscal year 2018	Fiscal year 2019
Income	20,000$	n / a
Costs of goods sold	10,000$	n / a
Inventory	5,000$	4,000$
Accounts receivable	500$	400$
Debts to pay	200$	300$

To get the DIP, DVP, and DPP for the CC formula, you must first determine the following:

• Average inventory: (5,000 + 4,000) / 2 = $ 4,500
• Average accounts receivable: (500 + 400) / 2 = $ 450
• Average Accounts Payable: (200 + 300) / 2 = $ 250

Here's how they would calculate each component of the CC formula using the numbers above:

• DIP: average inventory / cost of goods sold per day
• DVP: average accounts receivable / revenue per day
• DPP: average accounts payable / cost of goods sold per day

In our example, the above components would look like this:

• DIP: $ 4,500 / ($ 10,000 / 365 days) = 164.2 days
• DSO: $ 450 / (20,000 / 365 days) = 8.2 days
• DPO: $ 250 / (10,000 / 365 days) = 9 days

Then I would follow the above formula to calculate the CC: 164.2 + 8.2 - 9 = 163 days

To use the CCC metric correctly, the company would need to track the CCC across the time to see its progression and take advantage of the number to compare it with the competitors in the same market.

Importance of the cash cycle or cash cycle

The cash cycle metric offers an opportunity to track the available capital a business has to use to grow and other priorities. Having a lower cash cycle result can be an indicator of future growth and efficient operations.

For investors, tracking the cash cycle over several quarters can give them insight into the current and future health of the business. This number, when considered in conjunction with other factors, can also help investors choose between two competing companies that they are considering investing in.

For the company, knowing this data is essential not only to determine the monetary value and potential, but also also to identify possible bottlenecks in the process of production or sale of a product or service.

While metrics should never be considered in isolation, the cash cycle can be a useful tool to better understand a business from both an internal and external perspective.