When businesses invest in inventory, the money they spend is essentially tied up until the inventory sells. A company’s operating cycle refers to the length of time between when inventory is purchased and when it sells. A cash conversion cycle, on the other hand, is the period of time it takes for money committed to a particular aspect of running a business until it realizes a financial return on investment.
Although operating cycles and cash cycles may seem nearly identical at first glance, they actually have critical distinctions which set them apart. While an operating cycle charts the length of time it takes a product to sell after being purchased by a company, a cash conversion cycle follows the length of time needed to realize a financial return on a particular investment.
How Cash and Operating Cycles Work
As the old adage goes, you have to spend money to make money. Businesses have to to invest resources up front to support a variety of business functions. This includes but is not limited to:
- Startup costs
- Building and infrastructure
- Capital investments
- Inventory purchase
- Hiring and payroll
- Marketing and advertising
When money is allocated for these expenses, it means it is not available for other purposes. As such, the shorter the operating cycle of a business, the better. Businesses that can quickly turn investments into cash returns have greater liquidity and more buying power for moving the business forward.
Influences on Operating and Cash Cycles
A variety of factors have the potential to impact how quickly a business is able to turn investments into returns. The state of the national and local economy, the state of the industry, how well the business is managed and the degree of profit margin can all affect this cycle.
Ideally, a well-run business in a high-performing industry operating during an economic boom is the best scenario for a business. A stagnant market, slow-moving product or inventory or a highly competitive market all have the potential to result in a protracted cash cycle, in which money is tied up over a significant period of time, hampering a business' ability to be financially flexible.
Business Impact of Long Cycles
Long cycles have the potential to negatively impact businesses in a variety of ways. In addition to tying up cash reserves and credit lines, unsold inventory can also lose value when costs such as storage fees and interest on borrowed or invested funds start to eat into profit margins. This is especially critical in instances where profit margins are exceptionally thin, when inventory is perishable or becomes quickly outdated.
How Businesses Can Maximize Cycles
The faster a company can convert inventory to cash, the more profitable it will typically be. Maximizing cash and operating cycles reduces inventory overstock, ensures maximum return from investment and reduces the need for borrowing greater sums than necessary or paying excessive interest rates. It also helps ensure vendors are paid in a timely manner and that overall operating costs are well utilized.