Page 27 - DCOM505_WORKING_CAPITAL_MANAGEMENT

Working Capital Management

Notes 2.2.2 Significance of Operating Cycle

The operating cycle is conceptually simple but critically important.

Example: Let’s take the example of a greengrocer, who is ‘’cashing up’’ one evening.
What does he find? First, he sees how much he spent in cash at the wholesale market in the
morning and then the cash proceeds from fruit and vegetable sales during the day. If we assume
that the greengrocer sold all the produce he bought in the morning at a mark-up, the balance of
receipts and payments for the day will deliver a cash surplus.
Unfortunately, things are usually more complicated in practice. Rarely is all the produce bought
in the morning sold by the evening, especially in the case of a manufacturing business.
A company processes raw materials as part of an operating cycle, the length of which varies
tremendously, from a day in the newspaper sector to 7 years in the cognac sector. There is thus
a time lag between purchases of raw materials and the sale of the corresponding finished goods.

And this time lag is not the only complicating factor. It is unusual for companies to buy and sell
in cash. Usually, their suppliers grant them extended payment periods, and they in turn grant
their customers extended payment periods. The money received during the day does not
necessarily come from sales made on the same day.
As a result of customer credit, supplier credit and the time it takes to manufacture and sell
products or services, the operating cycle of each and every company spans a certain period,
leading to timing differences between operating outflows and the corresponding operating
inflows.
Each business has its own operating cycle of a certain length that, from a cash flow standpoint,
may lead to positive or negative cash flows at different times. Operating outflows and inflows
from different cycles are analysed by period, e.g., by month or by year. The balance of these
flows is called operating cash flow. Operating cash flow reflects the cash flows generated by
operations during a given period.
In concrete terms, operating cash flow represents the cash flow generated by the company’s
day-to-day operations. Returning to our initial example of an individual looking at his bank
statement, it represents the difference between the receipts and normal outgoings, such as on
food, electricity and car maintenance costs.

Naturally, unless there is a major timing difference caused by some unusual circumstances
(start-up period of a business, very strong growth, very strong seasonal fluctuations), the balance
of operating receipts and payments should be positive.

Self Assessment

Fill in the blanks:
4. The balance of operating receipts and payments is usually .................................
5. There is a need for working capital in the form of ……………to deal with the problem
arising out of the lack of immediate realisation of cash against goods sold.
6. ………………………..is the average time between purchasing or acquiring inventory and
receiving cash proceeds from its sale.
2.3 Cash Cycle

Cash conversion cycle expresses in days how long it takes a company to convert the materials it
purchases into cash. By checking how many days inventory it holds, how long it takes to collect

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