The Operating Cycle- Understanding How Much Cash You Need to Grow

Growing a business is challenging. If you’re going to grow your business without facing working capital deficits or gaps, you need to understand exactly how much capital you require. Otherwise, you’ll end up spending your time dealing with cash flow issues instead of working on your business. Understanding the operating cycle of cash is critical, and the actions you’ll take once you fully understand how to calculate your operating cycle will significantly enhance your cash position going forward.

WHAT IS THE OPERATING CYCLE?

Put simply, the operating cycle is the number of days your company takes to realize its product or service inventory in cash. It is calculated as follows:

average days of inventory held (A)
plus (+) average days for customers to pay you (B)
minus (-) average days to pay your suppliers (C)
= operating cycle (days)

As we all know, Alberta businesses in many sectors are experiencing very difficult credit conditions. I hear from a number of owner–operators that their line of credit is high, clients are not paying as quickly, and their financial institution is not supporting advances without added collateral. More and more companies are seeing deterioration in their operating cycle and will likely need to finance this gap.

This kind of credit crunch, which is cyclical in nature, requires extra vigilance. You must know the number of days between cash going out to purchase inventory, be it services or products, and when it comes back in from customers.

HOW DO I CALCULATE MY OPERATING CYCLE? BELOW IS AN EXAMPLE.

First you need to calculate each component of the operating cycle.

A. Average days of inventory held

To find this number you will need to calculate:

Daily cost of goods sold (COGS) (from INCOME STATEMENT)
e.g., COGS (2,150) divided by # of days in the year (365) = 5.89
Average inventory (from BALANCE SHEET)
Inventory previous year-end (250) plus inventory current year-end (325) = 287.5
Now take these two numbers and divide them to get the average number of days that your inventory is held.
287.5 divided by 5.89 = 48.8 days

B. Average days for customers to pay (average accounts receivable)

To find this number you will need to calculate:

Daily net sales (from INCOME STATEMENT)
Net sales (3,300) divided by number of days in the year (365) = 9.04
Average accounts receivable (from BALANCE SHEET)
Daily net sales (from INCOME STATEMENT)
Previous year-end (450) plus current year-end (425) = 437.5
Now divide the second number by the first to get the average number of days to be paid:
437.5 divided by 9.04 = 48.4 days

C. Average days to pay suppliers

To find this you will need to calculate:

Daily COGS (from INCOME STATEMENT—see A above) = 5.89
Average accounts payable (from INCOME STATEMENT):
Previous year-end (225) plus current year-end (175) = 200
Now divide the second number by the first to calculate the average number of days to pay suppliers: 200 divided by 5.98 = 40 days

Bring this all together now:

average days of inventory held 48.
plus (+) average days for customers to pay you 48.4
minus (-) average days to pay your suppliers 40
= 57.2 days in operating cycle (days)

SO HOW DOES THIS AFFECT YOUR GROWING COMPANY?

Assume your sales are growing by $1 million annually. How much additional working capital will be required to fund this growth?

Days in operating cycle (57) divided by number of days in the year (365) times $1 million = $156,164

Your business will require an additional $156,164 in working capital just to fund this growth. You’ll typically find this money in three buckets: cash, shareholder loans, or additional credit via your operating line.

GET THE INFO YOU NEED

Companies today are seeing significant changes in their operating cycles and are not adjusting as quickly as they need to. Growth, and especially significant growth, without the added working capital required could cripple your expansion or hamper your overall credit capacity so you require added collateral or an injection of other funds. Be sure your financial leadership is giving you this calculation every month or quarter to ensure you are aware of changes in the cycle.