The difference between the firm's operating cycle and its cash conversion cycle - Essay Example

It would only include time for the initial payment of cash by the company and the receipt of cash from the customers. Operating cycles are either short or long and both of these have serious implications for the company. An operating cycle which is short would mean that the company`s return on investment is rapid. A longer operating cycle, on the other hand, means that the company is not getting a quick return on investment and this probably affect the company in the long run. Operating cycles also differ according to the nature of the economy.

If there is an economic downturn, then the operating cycle of a company would probably last longer than the one during a period of an economic growth. The operating cycle of a company is also helps in the estimation of the amount of the working capital required by the company to maintain its growth. There are a number of factors influencing the duration or the time period of the operating cycle and these include the payment terms extended to the company by its suppliers. Also, a higher order fulfillment policy would increase the duration of the operating cycle.

The credit terms and payment policies of the company also affect the time period of the operating cycle. Therefore, operating cycles of a company are often affected the policies and decisions of a company as well as the policies of other companies towards the said company. The cash conversion cycle of a company is the time period required for a company to convert its resources cash flows. This cycle shows the time, in days, which a company takes to sell inventory, collect its receivables as well as pay all its bills.

This process of cash conversion shows the financial position of the company during a certain period of time. The cash conversion ratio is calculated through the collection of three ratios which are related to the inventory turnover which is the accounts receivable. This cycle shows how long an investment is in the production stage before being turned into cash. This cash conversion cycle is also known as the net operating cycle of a company. A company`s cash conversion cycle lengthens when it takes a longer time in collecting its accrued payments.

For small businesses especially, longer cash conversion cycles show the difference between its profits and bankruptcy as these companies highly rely on cash from such sales of inventories. One of the major differences between an operating and a cash conversion cycle is the difference in the calculation of both of these. In order to calculate the operating cycle, the duration of each component of the operating cycle needs to be determined and this includes raw materials, finished goods, work in progress etc.

the operating cycle is found out by summing these individual components. The requirement for working capital would be higher if the operating cycle is longer. On the other hand, cash conversion cycle is calculated using the days payable outstanding ratio as well as those elements used in the operating cycle calculation. The days payable outstanding is the average time taken by a company to pay its suppliers. The formula for cash conversion is days inventory outstanding + days sales outstanding – days payable outstanding.

All of these activity ratios are expressed in days and show the cash conversion cycle of the company. Both operating cycles and cash conversion cycles are really important for an owner as well as the company as the whole. The cash conversion cycle is extremely important for the financial analysis being done by the owner. This is because it shows the factors related to cash which is really important