Personal Finance

What’s the Difference Between Operating Cycle and Cash Cycle

Operating cycles and cash cycles are measures of how effective a company is at managing its cash. When a company invests in inventory, its cash is tied up until the items in question are sold. As a result, whatever cash is tied up is not available for other uses. It's therefore in a company's best interest to maintain as short an operating and cash cycle as possible, as doing so can maximize liquidity and minimize the costs involved in storing inventory.

Operating cycle

An operating cycle represents the amount of time it takes a company to acquire inventory, sell that inventory, and receive cash from its customers in exchange for the inventory sold. The length of a company's operating cycle is dictated by a number of factors, including the payment terms a company extends to its customers and those extended to the company by its suppliers. If a company is given more time to pay its suppliers for inventory, it can reduce its operating cycle by delaying the outlay of cash. On the other hand, if a company gives its customers more time to pay for goods received, it can extend its operating cycle, as the company will have to wait longer to get its cash. A shorter operating cycle indicates that a company's cash is tied up for a shorter period of time, which is generally more ideal from a cash flow perspective.

Cash cycle

Also known as a cash conversion cycle, a cash cycle represents the amount of time it takes a company to convert resources to cash. The cash cycle calculates the time during which each dollar is committed to various production and sales processes before it is then converted to cash in the form of accounts receivable, or paid invoices. The cash cycle begins when a company pays to purchase inventory and ends when that money is recovered by receiving payment from customers. When a company's cash is committed to production and sales processes, it is, by default, unavailable for other purposes, including investment and growth. A shorter cash cycle, therefore, indicates that a company has more reliable access to cash on hand, and more opportunities to use that cash to further the business.

Interaction of operating and cash cycle

While both cycles serve similar purposes, the operating cycle offers insight into a company's operating efficiencies, while the cash cycle offers insight as to how well a company is managing its cash flow. Additionally, it's often the case that one cycle impacts the other in practice. A shorter operating cycle can lead to a shorter cash cycle, while a longer operating cycle can result in a more lengthy cash cycle. It's therefore important for companies to analyze these cycles individually as well as jointly.

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