Accounting: The Language of Business - Vol. 2 (Intermediate: Part 150)

Don't be greedy for money (1 Peter 5:2)

 Short-Term Operating Assets: Cash and Receivables (Part O)

by

Charles Lamson

Financial

Statement

Analysis

Operating Cycle Analysis

Financial statement users consider cash management critical to a company's operations and ability to maintain and grow operations. Analyzing a company's cash management involves answering questions such as:

• How long does it take to collect cash?

• How long does it take to convert to cash?

• How long does it take to make payments?

• Does the company have sufficient cash, or does it need additional financing?

 

Operating Cycle

The operating cycle is the length of time it takes a company to generate cash from its operations, thereby providing answers to the questions of how long it takes a company to collect cash and how long it takes to convert inventory to cash. The following diagram illustrates the operating cycle:

We can use basic financial statement ratios to determine the length of a company's operating cycle. The operating cycle is computed as the number of days between when inventory is acquired and cash is collected on the sale of the inventory:

 Operating Cycle = Days Sales Outstanding + Days Inventory on Hand (9.1)

Financial analysts use the following ratios to compute a company's operating cycle: days sales outstanding and days inventory on hand.

Days Sales Outstanding

To determine the number of days that accounts receivable are outstanding, we start by computing the accounts receivable turnover ratio. The accounts receivable turnover ratio indicates how many times per year the firm goes from a full receivable balance to complete collection. 

Accounts Receivable Turnover Ratio = Credit Sales / Average Accounts Receivable (9.2) 

where

The higher the accounts receivable turnover ratio, the more frequently a company collects its receivables. For example, an accounts receivable turnover ratio of 12.0 indicates that a company turns over its receivables 12 times a year, or about once every month. Consider a manufacturer that extends credit and expects payment in 30 days. An accounts receivable turnover ratio of 12.0 would be expected given that there are 12 months in a year and payment is due within 30 days.

The accounts receivable turnover ratio can be used to determine the expected number of days it takes to collect accounts receivable balances. The days sales outstanding is the number of days a company takes to collect its receivables from customers. It is calculated by dividing the number of days in a year, 365, by the number of times accounts receivable turns in a year:

Days Sales Outstanding = 365 / Accounts Receivable Turnover Ratio (9.4)

This ratio is always also called the number of days sales and accounts receivable or the collection interval. If a manufacturer has an account receivable turnover of 12.0, its days sales outstanding would be 30.4 days, or about a month.

Days Inventory Is on Hand 

To estimate the number of days inventory is on hand, we begin by computing the inventory turnover ratio. The inventory turnover ratio indicates how many times per year the firm goes from a full inventory balance to selling all its inventory:

Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory (9.5)

The higher the inventory turnover ratio, the more frequently a company sells out its inventory. For example, an inventory turnover ratio of 4.0 indicates that a company turns over its inventory every quarter. Consider a clothing store that sells clothes for each season—winter, spring, summer, and fall. An inventory turnover ratio of 4.0 would be expected given the four seasons of clothing the store sells.

The inventory turnover ratio can be used to determine the expected number of days it takes a company to sell inventory. The days inventory on hand is the number of days that the company takes to sell its inventory; it is calculated by dividing the number of days in a year, 365, by the number of times that inventory turns over in a year.

Days Inventory on Hand = 365 / Inventory Turnover Ratio (9.7)

This ratio is sometimes called the number of days inventory held or the holding interval.

Cash Operating Cycle

To better understand a company's cash needs, the cash operating cycle assists a financial analyst in determining a company's ability to pay its suppliers when due. The cash operating cycle is the period of time it takes a company to pay its suppliers less the time a company takes to collect cash from sales. The cash operating cycle can help answer the question of whether a company has sufficient cash or needs additional financing. The cash operating cycle is also called the firm's cash-to-cash cycle or cash conversion cycle. The following diagram illustrates the cash operating cycle:

Now we need to consider the amount of time the company's suppliers allow it to repay accounts payable. If the accounts payable must be paid before cash is collected, the company may need to borrow or liquidate investments in order to pay the balance due.

The cash operating cycle is computed as:

Cash Operating Cycle = Days Accounts Payable Outstanding - Operating Cycles (9.8)

A positive cash operating cycle suggests that a company does not need to obtain additional financing to meet its cash needs. That is, excess cash can be used to pay off short-term lines of credit or reinvest in the business. The company is collecting cash sooner than it needs to pay its suppliers. A negative cash operating cycle means a company needs to obtain additional financing. It is collecting cash more slowly than it needs to pay its suppliers. A negative cash operating cycle can indicate that a company has poor cash management or that it is growing. For example, a company with a lenient credit extension policy could take longer to collect from its customers than to pay its suppliers. Alternatively, If a company is growing, it is likely purchasing more inventory from its suppliers, expecting future sales. Next, we explain the computation of days accounts payable outstanding.

Days Accounts Payable Outstanding

To estimate the number of days that accounts payable are outstanding, first compute the accounts payable turnover ratio. The accounts payable turnover ratio indicates the number of times per year a company goes from full accounts payable balances to full repayment:

Accounts Payable Turnover Ratio = Production or Purchases / Average Accounts Payable (9.9)

When we assume that a company's beginning inventory and ending inventory are approximately the same each year, cost of goods sold can be used as a proxy for purchases or production as illustrated by the following example:

Companies typically use the following ratio to measure accounts payable turnover:

 Accounts Payable Turnover Ratio = Cost of Goods Sold / Average Accounts Payable (9.10)

A higher accounts payable turnover ratio indicates that a company is paying off its payables frequently. For example, a company with an accounts payable turnover ratio of 12 pays its suppliers sooner than a company with an accounts payable turnover ratio of 6.

The accounts payable turnover ratio can be used to determine the expected number of days it takes to pay suppliers. The days accounts payable outstanding, the number of days a company takes to pay its suppliers, is calculated by dividing the number of days in a year, 365, by the number of times accounts payable turns over in a year:

Days Accounts Payable Outstanding = 365 / Accounts Payable Turnover Ratio (9.12) 

Example 9.16 illustrates computations for operating cycle and cash operating cycle. 

Source: L'Oreal Group, Annual Report, December 2016

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, PP. 469-472*

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