Operating and Cash Cycle

The operating cycle is the time it takes for a business to receive inventory, sell it, and then collect on those receivables. It is defined as the inventory period plus the accounts receivable period. The inventory period is the time inventory sits on the shelf, and the accounts receivable period is the time it takes to collect payments from customers.

The cash cycle is the time between paying for inventory and receiving payment from its sale. It is calculated as the operating cycle minus the accounts payable period. The accounts payable period is the credit time a supplier gives a business before payment is due. The cash cycle measures how long a business needs to finance inventory and receivables.

An example illustrates the cycles: inventory purchased on credit on day 0, paid for on day 30, sold on credit on day 60, and payment collected on day 105. This results in an inventory period of 60 days, an accounts receivable period of 45 days, an operating cycle of 105 days, and a cash cycle of 75 days (105 - 30 days accounts payable).

A diagram visually represents the timeframes for purchasing inventory, paying for it, selling it, and receiving payment. It highlights the inventory period, accounts receivable period, accounts payable period, operating cycle, and cash cycle, making the relationships clearer.

Businesses aim to shorten the cash cycle. This can be achieved by shortening the accounts receivable period (e.g., offering discounts for early payment like '2/10 net 30') or by extending the accounts payable period (negotiating longer payment terms with suppliers). Larger companies like Walmart can often negotiate more favorable terms due to their market power.

The inventory period is calculated as 365 divided by inventory turnover. Inventory turnover is cost of goods sold divided by average inventory. The accounts receivable period is 365 divided by receivables turnover, which is credit sales divided by average accounts receivable. The accounts payable period is 365 divided by payables turnover, which is cost of goods sold divided by average accounts payable.

An example demonstrates calculating these periods using given financial data. The average inventory, receivables, and payables are used to find turnover rates, which then determine the inventory period (111 days), receivables period (57 days), and thus the operating cycle (168 days). Managers seek to shorten these cycles for better financial management, like Dell's 'just-in-time' inventory strategy.