Efficiency, adaptability to the environment and their ability to remain in business for a long period of time. These depend on management ability to convert resources invested in the business within a short time. Net Operating Cycle (NOC) or as it is often called Cash Conversion Cycle (CCC) is one method to monitor this. Let us dive into it.
Definition — What is Cash Conversion Cycle
This is the length of time it takes to convert raw material to cash required to pay the entity’s obligations. The cycle includes purchase of raw materials by cash or on credit (Account Payable), converting it to work in progress and finished goods. Next, sales such goods or services to customers. Many customers pay in cash others on credit (Account Receivable). Ensure you collect the debt from debtors. And pay off obligations used to buy raw materials and other Account Payables. More to this, you can define net operating cycle as gross operating cycle minus account payable. I have explained the Gross Operating Cycle.
Key Explanations of Net Operating Cycle
Length of time. NOC involves time. Its calculation is based on days, weeks or months within a year. It is true that the shorter the time the better for the entity. However, there is no rule for this. Why? Because, Industries differ. Perishable goods businesses will require a very short cash conversion cycle. Real estate entities, however, have a longer period.
The conversion period. This starts with the purchase of raw material. And ends when cash is paid to settle debts the business owes creditors. To begin, raw materials are purchased on credit terms or cash are paid. Also, the entity may borrow money from the bank or other means to meet demand for the entity’s product. Next, the materials and suppliers are converted to finished goods.
Later on, the sales representatives sell the goods to customers. The customers may either pay in full (by cash) or be allowed to buy on credit and pay at a later date. Debtors or customers who owe debts may refuse to pay willingly unless they are forced to do so. A good recovery team is necessary to collect cash from debtors. The cash collected from debtors and that collected when the goods are sold are used to pay creditors and other debts as well as replenish inventory. This begins the circle.
How to Calculate Cash Conversion Cycle
I have explained Gross operating cycle (GOC). In the net operating cycle, the account payable period is deducted from GOC. The GOC of Computer Warehouse Group (CWG) is 187.3 Days. Now let’s calculate the account payable period.
The formula to calculate Account Payable period is (Average A/c Payable ÷ Credit Purchases) × 360 Days.
While Average A/c Payable is (Opening + Closing Account Payables) ÷ 2.
From CWG’s financial report the closing and opening Account Payables balances are NGN 6,762,143 and NGN 7,188,358 respectively. Therefore, the average payable is (6,762,143 + 7,188,358) ÷ 2. The result is 6,975,250.5.
The purchase for CWG is NGN 9,080,002. Therefore, the Account Payable period is 6,975,250.5 ÷ 9,080,002) × 360 days. Equals 276.55 days.
Therefore, the NOC is 187.3 days – 276.55 days. This gives a negative value of – 89.25 days. This implies that the cash conversion cycle for CWG is negative. It takes the company more time to pay up its debts. The company may pursue borrowing funds to meet current obligations. While waiting for cash to convert.
Why is understanding Cash Conversion Cycle Important
Every business has a unique NOC. But, it is the duty of the management to monitor it. When it takes a short time to convert the firm’s product to cash, it shows operational efficiency on the part of management. It also makes it easier to get loans from banks. In addition, the company can easily source for investment from potential investors. As they believe that their money is in good hands. What’s more, the business with a short cash conversion period can pay debts on time. And can pay dividend and taxes without looking back.
Finally, the cash conversion cycle is the time period between the purchases of raw materials and the recovery of cash to settle present obligations. A short conversation time reveals the operational efficiency of management. While a longer one is bad for business.