Operating Cycle & Cash Cycle: Definition & Calculations
https://youtu.be/OxWwS_q89mM
How can a business owner know how long it takes to make money on purchased supplies or products? In this lesson, we’ll examine the two different methods for calculating the length of time it takes to make a profit: the operating cycle and the cash conversion cycle.
Buying and Selling
Peter owns a company that sells office supplies to other companies. They buy the supplies from the people that make them, hold them in their warehouse (which is called inventory), and then sell and ship the inventory to their customers, the other companies.
Most businesses run one of two ways:
they buy supplies, or they manufacture products, and then pass on the product to the customer. just like Peter’s company, they buy products and resell them to the customer. Either way, it’s important that companies keep track of how long it takes them to make money after they buy supplies, because the shorter the time is, the better for your business operating .
So, how can Peter know how long it takes him to make money on the products he buys?
There are two different ways:
the operating cycle and the cash conversion cycle.
Let’s take a closer look at each of them.
what is Operating Cycle
One way that Peter could keep track of how long it takes to make money after he buys inventory is, the *operating cycle*, which is the best method to use if the company pays for their supplies or products at the time of the sale.
When the company pays for something at the time of a sale, it is said that they are paying in cash, even if the actual method is by writing a check,or transferring funds from one bank account to another.
In the operating cycle, there are three basic steps:
1.The company buys inventory with cash.
For example, Peter just bought a big shipment of computers from a computer company. He wrote a check on the day that the deal was made, and the computers are now sitting in his warehouse, waiting to be sold off.
2.The company sells the inventory for credit.
A week after Peter’s company received the computers, a store-bought the computers from them. Unlike Peter, the store didn’t write the check when they bought the computers. Instead, Peter gave them 30 days term after the sale happen. Peter goes ahead and ships the computers to the store, and they will pay him after 30 days have elapsed.
3.The company receives payment for the shipment. Finally, after the 30 days have passed, the store writes Peter’s company a check for the sale. They have now received the money and the cycle is complete.
So, what does these 3 operating cycles tell peter about the length of time it takes him to make money after buying inventory? if you are a busineess owner, it is important for you to know the length of time it take you to make money after buying inventory. not getting the inventory sitting in your warehouse ya.
Operating cycle can be calculated by *adding the inventory period* or how long Peter has inventory in his warehouse, and the accounts receivables period, or how long after the sale it takes for the company to pay.
Remember that the computers sat in Peter’s warehouse for a week before he sold them to the store, and then it took the store 30 days to pay. If Peter adds one week (or seven days) to 30 days, his operating cycle is 37 days long for this deal. That’s not bad!
A company’s organizational chart can influence the operating cycle.
It is critical that different leaders communicate clearly to keep things moving.
For example, Peter’s sales manager needs to let the billing department know quickly that the store has 30 days term to pay, so the billing department can follow up and keep things on track. Otherwise, the company operating cycle can stretch out.
what about Cash Conversion Cycle
As we said, the operating cycle is best used when a company pays cash for their supplies or products.
For example, remember that Peter wrote a check at the time that he bought the computers. But what if, like the store that Peter sold to, Peter wanted his company to buy inventory on credit instead of cash, and pay for it later?
The best option then is not to use the operating cycle, but to use the cash conversion cycle, which is about converting the credit of the company into cash. That is, it looks at how long it takes the company to make money when they buy their inventory with credit.
The first three steps of the cash conversion cycle are just like those of the operating cycle.
-The company buys supplies or products (in this case with credit instead of cash),
-sells the inventory for credit, and then
-receives payment for the shipped inventory.
But there’s a fourth step in the cash conversion cycle: the company pays their suppliers for the inventory.
For example, if Peter had bought the computers on credit, he would eventually have to pay the computer company for them.
The cash conversion cycle can be calculated by adding the inventory period and accounts receivables period and then subtracting the accounts payable period (or how long it takes the company to pay its suppliers).
The best option for most companies is to have a short inventory and accounts receivables period to get their money fast, but a long accounts payable period. That really shortens the period that the company has to go through before paying.
For example, let’s say that Peter has to pay the computer company 15 days after he receives the computers. Remember that his inventory period and accounts receivables period together were 37 days. If Peter subtracts 15 from 37, his cash conversion cycle is 22 days long.
But, what happens if Peter lengthens the accounts payable period? Let’s say that he has 30 days to pay, instead of 15. Now his cash conversion cycle is only 7 days long. That is, he will have made a profit in 7 days (instead of 22). That’s even better!
Lesson Summary
In Businesses have two ways of keeping track of how fast it takes them to make money on a purchase of supplies or products.
The first is the operating cycle, which is the best method to use if the company pays for their supplies or products at the time of the sale.
There are three basic steps in the operating cycle:
buying inventory with cash,
selling inventory for credit,
and receiving payment for sale.
The operating cycle can be calculated by adding the inventory period and the accounts receivables period.
If a business pays for their supplies and products with credit, it is best to use the cash conversion cycle, which is about converting the credit of the company into cash. That is, it looks at how long it takes the company to make money when they buy their inventory with credit.
The first three steps of the cash conversion cycle are just like those of the operating cycle.
But there’s a fourth step in the cash conversion cycle: the company pays their suppliers for the inventory. The cash conversion cycle can be calculated by adding the inventory period and accounts receivables period and then subtracting the accounts payable period.