Info

Collect on sale

+$1,400

The Operating Cycle There are several things to notice in our example. First, the entire cycle, from the time we acquire some inventory to the time we collect the cash, takes 105 days. This is called the operating cycle.

As we illustrate, the operating cycle is the length of time it takes to acquire inventory, sell it, and collect for it. This cycle has two distinct components. The first part is the time it takes to acquire and sell the inventory. This period, a 60-day span in our example, is called the inventory period. The second part is the time it takes to collect on the sale, 45 days in our example. This is called the accounts receivable period.

Based on our definitions, the operating cycle is obviously just the sum of the inventory and accounts receivable periods:

Operating cycle = Inventory period + Accounts receivable period 105 days = 60 days + 45 days

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

VII. Short-Term Financial Planning and Management

19. Short-Term Finance and Planning

© The McGraw-Hill Companies, 2002

CHAPTER 19 Short-Term Finance and Planning

What the operating cycle describes is how a product moves through the current asset accounts. The product begins life as inventory, it is converted to a receivable when it is sold, and it is finally converted to cash when we collect from the sale. Notice that, at each step, the asset is moving closer to cash.

The Cash Cycle The second thing to notice is that the cash flows and other events that occur are not synchronized. For example, we don't actually pay for the inventory until 30 days after we acquire it. The intervening 30-day period is called the accounts payable period. Next, we spend cash on Day 30, but we don't collect until Day 105. Somehow, we have to arrange to finance the $1,000 for 105 - 30 = 75 days. This period is called the cash cycle.

The cash cycle, therefore, is the number of days that pass before we collect the cash from a sale, measured from when we actually pay for the inventory. Notice that, based on our definitions, the cash cycle is the difference between the operating cycle and the accounts payable period:

Cash cycle = Operating cycle - Accounts payable period 75 days = 105 days - 30 days

accounts payable period

The time between receipt of inventory and payment for it.

cash cycle

The time between cash disbursement and cash collection.

Figure 19.1 depicts the short-term operating activities and cash flows for a typical manufacturing firm by way of a cash flow time line. As shown, the cash flow time line presents the operating cycle and the cash cycle in graphical form. In Figure 19.1, the need for short-term financial management is suggested by the gap between the cash inflows and the cash outflows. This is related to the lengths of the operating cycle and the accounts payable period.

cash flow time line

A graphical representation of the operating cycle and the cash cycle.

Cash Flow Time Line and the Short-Term Operating Activities of a Typical Slide 19.6 Manufacturing Firm

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