Operating Cycle vs. Cash Conversion Cycle | Financial Statement Analysis

The operating cycle is the sum of (a) days sales outstanding and (b) days sales in inventory. Thus, the operating cycle is the number of days it takes the company to sell inventory and collect cash from customers. This is the total amount of time for which the company must finance its inventory.

When suppliers ship inventory to the company on credit, they are effectively providing financing to the company. Thus, the cash conversion cycle (aka the cash-to-cash cycle or cash operation cycle) is the operating cycle minus days payable outstanding. The cash conversion cycle is the amount of days the company must find other financing (not from suppliers) for the inventory.

For example, assume a company's operating cycle is 70 days. If the company's days payable outstanding is 30 days, this means its suppliers are providing financing for 30 days. Thus, 30 days after purchasing the inventory from suppliers the company must pay cash for that inventory. However, it will still be another 40 days (70 - 30 = 40) before the company receives cash from its customers. The company must therefore find a way to finance the inventory for 40 days (e.g., short-term borrowing).

Companies therefore have an incentive to make the cash conversion cycle as short as possible. The shorter the cash conversion cycle, the less the company needs to rely on short-term borrowing.
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