OPERATING CYCLE AND CASH CONVERSION CYCLE

LEARNING OBJECTIVES

• Describe the operating and cash conversion cycles and why they are important.

• List the components of operating and cash conversion cycles.

• Use both the operating cycle and cash conversion cycle to analyze the firm's working capital.

DEFINING THE OPERATING CYCLE

Events in the Operating Cycle

1. Buying Raw Materials

2. Paying Cash

3. Manufacturing the Product

4. Selling the Product

5. Collecting Cash

Decisions in the Operating Cycle

1. How much inventory to order

2. Whether to borrow or draw down cash balances

3. What choice of production technology to use

4. Whether credit should be extended to a particular customer

5. How to collect cash

LET'S PRACTICE

Case Study: Penny Blossom

• Context: Penny Blossom, a company that produces hair clips, wants to understand its cash conversion cycle better.

• Question: Which of the following represents the correct order of events in Penny Blossom's business process?
    - A) Buying raw materials → Manufacturing the product → Paying cash → Selling the product → Collecting cash
    - B) Paying cash → Buying raw materials → Manufacturing the product → Selling the product → Collecting cash
    - C) Buying raw materials → Paying cash → Manufacturing the product → Selling the product → Collecting cash
    - D) Manufacturing the product → Buying raw materials → Paying cash → Selling the product → Collecting cash

DEFINING THE OPERATING CYCLE (WITH EXAMPLE)

• Example:
    - Day 0: We purchase $1,000 worth of inventory on credit.
    - Day 30: We pay the $1,000 bill.
    - Day 60: Someone buys the $1,000 in inventory for $1,400.
    - Day 105: Our buyer does not pay for another 45 days.

• Cash Effect Summary:
    - From each of these activities, we can summarize the cash effect detailed.

KEY MEASURES OF THE OPERATING CYCLE

• Definition: Operating cycle is the time between the acquisition of inventory and the collection of cash from receivables.
    - Inventory Period (Days of Inventory): Time taken to acquire and sell the inventory.
    - Accounts Receivable Period (Days of Receivable): Time between sale of inventory and collection of the receivable.

OPERATING CYCLE FORMULA

• Formula:
    - Operating Cycle = Days of Inventory + Days of Receivable
    - Example Calculation:
      - $ext{Operating Cycle} = 105 ext{ days} = 60 ext{ days (Days of Inventory)} + 45 ext{ days (Days of Receivable)}$

LET'S PRACTICE

Case Study: Operating Cycle Calculation

• New Scenario for Penny Blossom:
    - Day 0: Purchases $2,000 worth of crafting materials on credit.
    - Day 25: Pays the $2,000 bill for materials.
    - Day 40: Sells the finished hair clips for $3,000, allowing 50 days for payment.
    - Day 90: Receives payment from the boutique.

• Question: What is Penny Blossom's operating cycle?
    - A) 40 days
    - B) 50 days
    - C) 90 days
    - D) 65 days

DEFINING THE CASH CONVERSION CYCLE

• Accounts Payable Period (Days of Payable): Time between receipt of inventory and payment for it.

• Cash Conversion Cycle (Cash Cycle): Time between cash disbursement and cash collection.

CASH CONVERSION CYCLE FORMULA

• Formula:
    - Cash Conversion Cycle = Operating Cycle - Days of Accounts Payable
    - Example Calculation:
      - $ext{Cash Conversion Cycle} = 75 ext{ days} = 105 ext{ days (Operating Cycle)} - 30 ext{ days (Days of Accounts Payable)}$

LET'S PRACTICE

• Scenario: Calculate Penny Blossom's cash conversion cycle given previous data and information.

CASH FLOW TIMELINE

• Operating Cycle:
    - Period from inventory purchase until cash receipt.
    - May not include time from order placement until inventory arrival.

• Cash Cycle:
    - Period from cash payment to cash receipt.

CALCULATING THE OPERATING AND CASH CONVERSION CYCLES

• Calculation from Financial Statements:
    - Analyze financial statement details to derive necessary ratios and cycle times.

CALCULATING THE OPERATING CYCLE

1. Inventory Turnover:
     - Noted that the firm turned over inventory 3.28 times during the year.
     - Closing Inventory: Used to calculate inventory turnover is noted as significant for financial analysis.

2. Average Holding:
     - Average inventory held = 111 days.

3. Days of Inventory:
     - Formula:
       - $ext{Days of Inventory} = ext{Average Inventory Held}$

LET'S PRACTICE

• Question: What is Penny Blossom's days inventory?

CONTINUING THE OPERATING CYCLE CALCULATIONS

• Actionable Insights:
    - Receivables were turned over 6.39 times during the year, relating to sales efficiency.

OPERATING CYCLE SUMMARY

• Calculation of Total Operating Cycle:
    - Operating cycle = 111 days (Days of Inventory) + 57 days (Days of Receivables) = 168 days.

FINAL PRACTICE QUESTIONS

• Operating Cycle Estimation for Penny Blossom from financial information provided with balance sheet data.

CALCULATING CASH CONVERSION CYCLE

1. Payables Turnover:
     - Payables turnover calculated from cost of goods sold against average payables.
     - $ext{Payables Turnover} = rac{ ext{Cost of Goods Sold}}{ ext{Average Payables}}$.

2. Days Payable Calculation:
     - Days Payable = 39 days as derived from application of turnover ratios.

CASH CONVERSION CYCLE FINAL FORMULA

• Final Calculation:
    - Cash conversion cycle = $168 ext{ days (Operating Cycle)} - 39 ext{ days (Days of Payables)} = 129 ext{ days}$

FINAL PRACTICE

• Final Query for Penny Blossom: Determine cash conversion cycle based on the explained practices above.

CASH TURNOVER RATIO

• Cash Turnover Ratio calculation based on Cash Conversion Cycle derived earlier:
    - $ext{Cash Turnover} = rac{365 ext{ Days}}{ ext{Cash Conversion Cycle}}$
    - Sample calculation indicates firm goes through 4.5 cash conversion cycles if cash conversion cycle is 81.03 days.

LET'S PRACTICE

• Evaluate Penny Blossom’s cash turnover using similar financial metrics as previously outlined.

SESSION WRAP-UP

• Key takeaways on understanding and applying Operating Cycle and Cash Conversion Cycle in business evaluations.