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What is the Difference Between the Firm’s Operating Cycle and its Cash Conversion Cycle?

It is known that in order to understand the working efficiency of any firm, it is necessary to make analysis of its operating cycle and its cash conversion cycle. Although these accounting concepts have very much in common, there are certain differences between them. It is known that operating cycle and cash conversion cycle help investors and financial experts to understand the way the firm generates its revenue from business operations.




The firm’s operating cycle shows the firm’s ability “to convert raw materials and resources into liquid cash”. The term operating cycle denotes the average period of time between purchasing inventory and receiving some cash from its sale. In other words, the firm’s operating cycle is defined as the number of days between these two processes. The firm’s operation cycle plays a major role in the cash flow of any firm or company.(Thadani)


The firm’s operating cycle can be short and long. A short operating cycle is a short period of time between two processes: the process of purchasing inventory and the process of recovering investment. In this case, the firm will recover its investment rather quickly. It means that the firm will realize its profit within a short period of time. A long operating cycle of the firm denotes that the cash is tied up in the firm’s inventory and receivables for a rather long period of time before the firm can recover its primary investment. It is known that the firm’s investments with this operating cycle are considered to be “sound” while the firm has enough capital to meet its short term obligations. So, if the firm’s operating cycle is long, the financial experts or investors know that the firm requires too much time to convert production processes into sales proceeds. This fact influences the efficiency of the business and the firm’s financial management to a great extent. That is why a short operating cycle is preferred for any firm or company. A short operating cycle shows that a firm can convert raw materials into cash rather fast. It is recommended to reduce the number of days in the firm’s operating cycle in order to increase the firm’s efficiency. In this case, the firm will have more liquid cash in order to meet obligations. (Thadani)


Operating cycle depends on the nature of business, the type of inventory and the credit terms of the firm. For example, food industries have a rather short operating cycle while manufacturing industries or construction firms have a rather long operating cycle.The firm’s cash conversion cycle is an accounting concept which gives opportunity to analyze the time and money involved in business. Cash conversion cycle can help to measure the risk of the firm’s cash crunch in case of expansion or investment of new projects. It is known that cash conversion cycle is sometimes called assert conversion cycle. It can measure the amount of time necessary for the business to recover all the money invested into business in order to pay credits and to generate the firm’s profit. In other words, cash conversion cycle denotes the number of days which are required for the firm to recover its primary investment and to generate its sales. (Pilgrim)


It is known that cash conversion cycle includes three parts that are necessary to measure the time: days in inventory, days sales outstanding and days payable outstanding. Cash conversion cycle formula is the following one: Days in inventory + days sales outstanding – days payable outstanding. If cash conversion cycle is negative, the firm pays its credits to creditors after the payments have been recovered from the customers. The shorter cash conversion cycle, the better. It is also known that the analysis of the cash conversion cycle of the firm is very important as it tests the efficiency of the firm’s business. Cash conversion cycle analysis give opportunity to the credit analysts to determine when the firm needs more cash to operate and how the firm will repay the cash. Cash conversion cycle is very important for the retail type companies which sell their inventories to the customers. However, insurance companies or consulting companies do not require cash conversion cycle analysis. (Pilgrim)


CONCLUSION
In conclusion, it is necessary to say that cash flow plays an important role in any business organization. I think that the most important accounting concept for the owner of the firm is operation cycle as it gives opportunity to understand the amount of working capital that the firm requires in order to run its business. It is recommended to make everything possible to reduce the firm’s operating cycle and to lower the amount of working capital.

Works Cited
Pilgrim, G. Understanding the Cash Conversion Cycle. Buzzle.com. Cash Flow. December, 13, 2010. Available from:
Thadani, R. Cash Operating Cycle. Buzzle.com. November 12, 2010. Retrieved from: