The cash cycle, also known as the cash conversion cycle, is a financial metric that measures the time it takes for a company to convert its investments in inventory and other resources into cash received from sales. The cash cycle is used to evaluate a company’s efficiency in managing its working capital.
The cash cycle is typically measured in days and includes three components:
- Inventory Days: The number of days it takes for a company to sell its inventory.
- Accounts Receivable Days: The number of days it takes for a company to collect payment from its customers after making a sale.
- Accounts Payable Days: The number of days it takes for a company to pay its suppliers for inventory and other expenses.
The formula for calculating the cash cycle is as follows:
Cash Cycle = Inventory Days + Accounts Receivable Days – Accounts Payable Days
For example, if a company has an inventory turnover of 5 times per year, an average collection period of 60 days, and an average payment period of 45 days, the cash cycle would be:
Inventory Days = 365 days / 5 = 73 days Accounts Receivable Days = 60 days Accounts Payable Days = 45 days
Cash Cycle = 73 + 60 – 45 = 88 days
This means that it takes the company an average of 88 days to convert its investments in inventory and other resources into cash received from sales.
A shorter cash cycle is generally preferable, as it means that a company is able to generate cash more quickly and efficiently. However, a very short cash cycle may also suggest that a company is not investing enough in inventory or may be overly aggressive in its sales and collections practices. Conversely, a long cash cycle may indicate that a company is experiencing cash flow difficulties or is not managing its working capital effectively.