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Explore how the operating cycle and cash conversion cycle reveal insights into a company’s liquidity and financial health.
The operating cycle and the cash conversion cycle are two critical concepts that help businesses measure efficiency in managing working capital. Both cycles provide insights into how quickly a company can turn its resources into cash flow, but they differ in scope and calculation. Understanding these measures helps businesses plan liquidity, manage credit, and improve operational efficiency.
The operating cycle refers to the total time taken by a business to convert its inventory and other inputs into cash through sales. It covers the journey from purchasing raw materials to collecting cash from customers.
In essence, the operating cycle indicates how many days it takes to complete the full cycle of operations — from investing in inventory to realising sales revenue. A shorter cycle indicates efficient operations and quicker cash recovery.
The formula for the operating cycle is:
Operating Cycle = Inventory Period + Receivables Period
Where:
Inventory Period = Average time taken to sell inventory
Receivables Period = Average time taken to collect payments from customers
This calculation shows how much time is required for a business to complete its sales and collection process.
Suppose a company takes 45 days to sell its inventory and 30 days to collect receivables.
Operating Cycle = 45 + 30 = 75 days
This means the business takes 75 days to convert its investment in inventory into cash.
The cash conversion cycle (CCC) is a more refined measure that accounts for the time a company takes to pay its suppliers as well. It calculates how long it takes for a company to convert investments in inventory and other resources into cash inflows, after considering the delay in payments to suppliers.
The CCC includes payables in its calculation, providing a broader perspective on liquidity than the operating cycle alone.
The formula for the cash conversion cycle is:
Cash Conversion Cycle = Operating Cycle – Payables Period
Where:
Payables Period = Average time taken to pay suppliers
This adjustment shows the net time a company’s cash is tied up in operations.
Continuing with the earlier example:
Inventory Period = 45 days
Receivables Period = 30 days
Payables Period = 25 days
Cash Conversion Cycle = (45 + 30) – 25 = 50 days
This means the company’s cash is tied up for 50 days before it is recovered through sales.
Here’s a side-by-side comparison of both measures:
| Aspect | Operating Cycle | Cash Conversion Cycle |
|---|---|---|
Definition |
Time taken to convert inventory into cash through sales |
Time taken to convert resources into cash, adjusted for payables |
Formula |
Inventory Period + Receivables Period |
Operating Cycle – Payables Period |
Scope |
Focuses on sales and receivables |
Focuses on sales, receivables, and supplier payments |
Insight Provided |
Efficiency of inventory and receivables management |
Net liquidity position and cash efficiency |
Both ratios are important for businesses:
Liquidity Planning: Helps firms manage cash inflows and outflows effectively.
Operational Efficiency: Highlights bottlenecks in inventory, receivables, or payables management.
Credit Assessment: Used by banks and investors to evaluate a company’s financial health.
Strategic Decision-Making: Guides policies on supplier terms, credit to customers, and inventory management.
Despite their importance, these ratios have limitations:
Industry benchmarks vary, making cross-industry comparisons less useful.
Seasonal businesses may show distorted figures.
Both ratios are historical in nature and may not reflect future performance.
External factors like supplier delays or customer defaults can affect reliability.
The operating cycle and cash conversion cycle are key measures of working capital efficiency. While the operating cycle focuses on the time taken to sell inventory and collect receivables, the CCC provides a more accurate picture by including supplier payments. Businesses should track both measures regularly to improve liquidity and maintain financial stability.
This content is for informational purposes only and the same should not be construed as investment advice. Bajaj Finserv Direct Limited shall not be liable or responsible for any investment decision that you may take based on this content.
The operating cycle measures the time taken to sell inventory and collect receivables, while the cash conversion cycle adjusts this figure by subtracting the time taken to pay suppliers.
The operating cycle focuses only on sales and receivables, whereas the cash conversion cycle includes payables, making it a more comprehensive liquidity measure.
An operating cycle is the period a business takes to purchase inventory, sell it, and collect payments, reflecting how quickly operations are converted into cash inflows.
The cash conversion cycle measures how long a company’s cash is tied up in operations after accounting for supplier payments. It highlights the net liquidity impact of business operations.
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