Cash Cycle Definition
A cash cycle is defined as the time it takes a company to turn raw materials into cash. It is also a common concept in any business which processes materials. Also known as the cash conversion cycle, it refers to the time between purchasing the raw materials used to make a product and collecting the money from selling the product. It also functions well as a measure of liquidity: how easily can unfinished product be turned into cash.
(Find out if reducing your cash conversion cycle is worth the effort!)
Cash Cycle Explanation
Cash cycles are typically measured in days. A shorter cash cycle is better than a longer cash cycle. A company with a shorter cash cycle has more working capital and less cash tied up in inventory and receivable accounts, which means it is less dependent on borrowed money. Cash cycle depends largely on operational efficiency. Factors that effect the cash cycle include labor efficiency, the quality of raw materials, quality of equipment, efficiency of management structures for processing materials, economic and market influencers, and more.
Cash Cycle Formula
Simply, the cash cycle calculation can be performed with:
When measured in years the cash cycle equation is:
Cash Cycle Example
Ronald owns a custom gun smithing service. As a sole proprietor, Ronald has never paid much attention to creating financial statements as long he could pay his bills. Due to the recent change in national administration and economic state, he has had to change this view to accommodate increased demand for his services. Ronald is curious how long it takes him to convert materials to income. With this he will attempt to increase efficiency as well as production capacity. Studying his cash conversion cycle provides insight into his work processes as well as the liquidity of his business operations.
Ronald will begin by completing the process in a simple way. He begins keeping a pad close while he works to monitor how long it takes him to make a product.
Then, Ron looks in his quick books to find out the average amount of time it takes him to be paid. He has never been much of a collections agent but is still a little disturbed by how long it takes customers to pay. Ron puts his heart and soul into his work and feels he deserves better.
Finally, Ronald looks back to see how long it takes him to pay his suppliers. Ron has never pushed for credit terms and realizes that he has always paid vendors upfront.
Improve Your Cash Cycle
Ron finds a cash cycle template online to simplify his calculation. Ron’s eyes are opened from this experience. His method of doing business as a sole proprietor was satisfactory but Ron will have to make some changes to accept the success that he can freely receive. He knows he is ready for the change but considers hiring a business consultant to make sure he does the job right the first time. He takes a moment to think about the future and smiles; Ronald is ready for the challenge that awaits him.
For more ways to improve your cash cycle, download your free A/R Checklist to see how simple changes in your A/R process can free up a significant amount of cash.
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