## Tuesday, June 9, 2009

### Cash Flow and Operating Cycle

I've written about cash flow with queuing theory as the lifeblood of business in my blog, as well as activity (operations) ratios in my financial profitability analysis series on my investment blog, but I wanted to review an interested concept in the CFA level I regarding the cash conversion cycle.

First let's do a review of the tools and topic. Firstly, what affects operations from a cash flow perspective? Using the direct method, the operating items which affect cash flow is change in working capital and the three items that affect that is Accounts Payable (AP), Accounts Receivable (AR) and Inventory (Inv). Now let's look at a standard process for how changes in each affect the operating cycle.

Order of Operations (like the BEDMAS of elementary arithmetic):
1. Purchase supplies from vendor on credit (AP up, Inv up)
2. Process supplies into goods for sale
3. Sell products on credit (Inv down, AR up)
4. Pay back supplier (AP down, cash down)
5. Receive payment from customers (AR down, cash up)
Notice that you don't actually receive any cash until step 5, but you have to pay it back in step 4. This means that you have a negative cash flow until you complete the cycle.

Recall that in the indirect method (calculating CFO from NI):
• If more inventory is made than sold, some "cash value" is retained in Inventory (Inv up, cash down)
• Alternately, if more inventory is sold than made, then you are liquidating your inventory (Inv down, cash up)
• An increase in AP means that you owe your supplier more money. This means that instead of paying with cash, you paid with credit so your cash flow goes up
• A decrease in AP therefore means you paid back your debts
• An increase in AR means that your customers paid you with credit so your cash flow goes down
• A decrease in AR therefore means you were paid back (collected on sales on account)
This next little diagram illustrates the relationship between Operating Cycle, DOH, DSO, Days Payables and Cash Conversion Cycle:
Operating cycle is simply the time it takes from when you purchase supplies to when you collect the cash and is composed of two components, Days Inventory on Hand (DOH) and Days Sales Outstanding (DSO).
• Days Inventory on Hand includes the manufacturing process, as well as storage. In accounting terms, this means works-in-progress (WIP), finished goods, sales cycle.
• Days Sales Outstanding is the time between sales on credit and the collection of cash.
• Cash conversion cycle is the time between when you pay your vendor to when you yourself collect cash. It is the difference between operating cycle and Days Payables.
In looking at which company is more likely to have cash flow problems, cateris paribus, it would be the company with the largest cash conversion cycle. That is to say, it has a low Days Payables (bills due sooner - cash out), but a long Operating Cycle (takes really long to produce and sell goods as well as collect on credit - cash in). So the larger the cash conversion cycle, the worse the operational and implicit structural liquidity.