Also known as the cash conversion cycle or operating cycle, the cash cycle is a method of analyzing the liquidity of a company. It measures the amount of time it takes an investment in raw material to produce a return on investment when the end product is sold. If capital is considered a measure of a company's strength, the cash cycle is a measure of its agility. Financial ratios such as the current ratio or acid test may vary greatly from industry to industry, due to differences in production or inventory requirements, while the cash cycle is an effective measure of efficiency relative to other companies in the same industry.

While the concept of time from initial purchases to collection of accounts receivable seems a simple one, an accurate measurement must consider that items may be at different stages in the manufacturing or production process. For an established company, one method of measurement is to calculate the amount of unsold inventory in terms of days' sales, then add the time it takes customers to pay, and subtract the delay in paying one's own suppliers.

cash cycle = Days Sales In Inventory + Days Sales Outstanding - Days Purchases Outstanding

It is important for a company to attempt to minimize its cash cycle, since it reflects the amount of working capital currently tied up in production which cannot be used for investment without liquidation. A smaller company with less capital may be able to compete with a larger one, if its cash cycle is shorter. Keeping inventory levels low is the primary method. Improving production efficiency often requires additional investments and is typically not an easy option. Companies of course always aim to be slow in paying their supplier, but expect rapid payment from their reseller - which of course impacts their cash cycles adversely. A good supply chain and a good partnership with a reseller are not usually worth such a risk.

Lengths of cash cycle vary greatly. In some industries such as gambling, it may be a matter of minutes, while other industries such as whisky distilleries are at the opposite extreme, taking years. Powerful companies such as Wal-Mart have short cash cycles (consisting not only of perishable goods in the inventory but also a considerable amount of consumer database analysis to keep inventory at precise levels). However, even the smallest startup company can be at the mercy of the cash cycle, since it reflects exactly how long the company must survive before its first income.

References

Source material for this article was obtained from:

http://www.investorwords.com/cgi-bin/getword.cgi?761
http://www.peoi.org/Courses/finanal/ch/ch8b.html
http://www.onlinewbc.gov/docs/finance/cashfl_pop.html