Working capital operating cycle Investment in working capital is influenced by four key events in the production and sales

cycle. These events are: purchase of raw materials, payment for their purchase, the sale of finished goods, and collection of cash for the sales made. Definition of operating cycle The time lag between the purchase of raw materials and the collection of cash for sales is referred to as the operating cycle for the company. The time lag between the payment for raw materials purchases and the collection of cash from sales is referred to as the cash cycle. Operating cycle of the company The entire sequence of operations in a company can be summarised as follows:

The operating cycle for a company primarily begins with the purchase of raw materials, which are paid for after a delay representing the creditor's payable period. These purchased raw materials are then converted by the production unit into finished goods and then sold. The time lag between the purchase of raw materials and the sale of finished goods is known as the inventory period. Upon sale of finished goods on credit terms, there exists a time lag between the sale of finished goods and the collection of cash on sale. This period is known as the accounts receivables period.

The following ratios will help in managing debtors, creditors and inventories 1. Stock Turnover ratio = Cost of goods sold / Average Stock 2. Debtors Turnover ratio = [(Debtors+ Bills receivable*365] / Net credit sales 3. Debtors Turnover rate = Credit sales / (Average Debtors + Bills receivable ) 4. Creditors Turnover ratio = [(Creditors + Bills payable)*365] / Credit purchases 5. Creditors Turnover rate = Credit purchases / Average Creditors The operating cycle can be depicted as:

The stage between purchase of raw materials and their payment is known as the creditors payables period. The period between purchase of raw materials and production of finished goods is known as the inventory period. The period between sale of finished goods and the collection of receivables is known as the accounts receivable period.

Cash Conversion Cycle The cash conversion cycle is a measure of working capital efficiency, often giving valuable clues about the underlying health of a business. The cycle measures the average number of days that working capital is invested in the operating cycle. It starts by adding days inventory outstanding (DIO) to days sales outstanding (DSO). This is because a company "invests" its cash to acquire/build inventory, but does not collect cash until the inventory is sold and the accounts receivable are finally collected. Receivables are essentially loans extended to customers that consume working capital; therefore, greater levels of DIO and DSO consume more working capital. However, days payable outstanding (DPO), which essentially represent loans from vendors to the company, are subtracted to help offset working capital needs. In summary, the cash conversion cycle is measured in days and equals DIO + DSO DPO:


Here we extracted two lines from Kohl's (a retail department store) most recent income statement and a few lines from their working capital accounts.

Circled in green are the accounts needed to calculate the cash conversion cycle. From the income statement, you need net sales and COGS. From the balance sheet, you need receivables, inventories and payables. Below, we show the two-step calculation. First, we calculate the three turnover ratios: receivables turnover (sales/average receivables), inventory turnover(COGS/average inventory) and payables turnover (purchases/average payables). The turnover ratios divide into an average balance because the numerators (such as sales in the receivables turnover) are flow measures over the entire year. Also, for payables turnover, some use COGS/average payables. That's okay, but it's slightly more accurate to divide average payables into purchases, which equals COGS plus the increase in inventory over the year (inventory at end of year minus inventory at beginning of the year). This is better because payables finance all of the operating dollars spent during the period (that is, they are credit extended to the company). And operating dollars, in addition to COGS, may be spent to

increase inventory levels. The turnover ratios do not mean much in isolation; they are used to compare one company to another. But if you divide the turnover ratios into 365 (for example, 365/receivables turnover), you get the "days outstanding" numbers. Below, for example, a receivable turnover of 9.6 becomes 38 days sales outstanding (DSO). This number has more meaning; it means that, on average, Kohl's collects its receivables in 38 days.

Here is a graphic summary of Kohl's cash conversion cycle for 2003. On average, working capital spent 92 days in Kohl's operating cycle:

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