Cycle sale for operations

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analyzing the length of a company's operating cycle and its cash conversion cycle is very helpful not just in terms of analyzing business performance and understanding how quickly the company sells its inventory and collects cash from customers but also in terms of understanding the extent to which this company is going to need to rely on short-term borrowing to finance purchases of its inventory but first let me show you how these are calculated let's start with the operating cycle the operating cycle is just the sum of the days to sell inventory and day sales outstanding if you remember day sales outstanding is how long it takes the company to collect a credit sale that it made to a customer so if they sell to a customer they bill the customer and the customer pays 28 days later that would be day sales outstanding okay so you add these two together the operating cycle is telling you here's the number of days it takes this company to sell the inventory and then get cash from the customer so if this was 56 right if that was the length of the operating cycle that means it takes this company 56 days to sell the inventory build a customer and get cash from the customer okay so this is the number of days it takes to convert the inventory to cash not just to sell the inventory but to actually turn the inventory into cash so you could think about that also the operating cycle is the total number of days that this company needs to finance its inventory okay because when they get the inventory they don't immediately convert it to cash they have to sell the inventory and then they have to build a customer and get the cash from the customer so the operating so in this case it'd be 56 days before they're going to get any cash on the customer so they need to somehow finance that inventory that time period now here's where days payable outstanding comes into the picture and this is going to get in the cash conversion cycle days payable staying if we take that and remember that's just the number of days it takes this company to pay its suppliers if we take that and subtract it okay from the operating cycle so we've got the operating cycle which is again just the sum of day sales uh days of cell inventory and day sales outstanding so if we take the operating cycle and then subtract days payable outstanding that will give us the cash conversion cycle which is sometimes people called the cash to cash cycle cash operating cycle they're all all referring to the same thing so why is it that this cash conversion cycle we're subtracting days payable outstanding and what are we doing here here's the intuition okay so hopefully this this little equation will be helpful to you let me walk you through it so the operating cycle says okay look it's going to be 56 days before we get cash from the customer okay we've got to sell the inventory we got to collect the cash now the question is how are we going to finance the inventory during that 56 days what are we going to do how are we going to get the cash for this so days payable outstanding you could think about that as this is really financing that is being provided by suppliers why because your suppliers are not demanding cash immediately for the inventory okay so to the extent that they are not demanding cash immediately let's just say for example the days payable outstanding was 27. okay so now you subtract that from the 56 from the operating cycle okay so what does that come out to uh my math looks like 29. okay so that would be the cash conversion cycle so that means that basically the supplier is saying look for 27 days we'll finance the input like we got you we got you for 27 days but at 27 days you got to pay you know after 2017 you got to pay that supplier but you still haven't got the cash from the customer yet okay you still have another 29 days before you're gonna get the cash and the customers so the supplier right they took care of 27 days in this hypothetical example but the entire operating cycle is 56 you still don't have the cash in the customer so the remaining 29 days that's the days that are requiring other financing okay and that's what the cash conversion cycle is measuring this is days requiring other financing so basically what is this the higher the higher this is so 29 in this case but let's say it went to 35 it went to 42. let's say it was going up over time that's not good for the company right that's not good the company wants us to be lower right you you want it to be lower because the long the higher this number is this cash conversion cycle the higher that number is that means that the company's having to more and more days that they have to find other financing financing not from the supplier but somebody else so who would be that somebody else well that's where they might have to engage in short-term borrowing okay they're having to borrow money because they're having to pay that supplier even though so it's been 27 days they have not got the cash yet it's gonna be 56 days before they get the cash from the customer okay so they're having to engage in short-term borrowing so even if you have a great company and they're doing well and they're selling product but they could have a cash crunch because of this issue here if they haven't uh properly managed their cash right and their cash conversion cycle is increasing uh and and for some reason the company can't access short-term credit could lead to a problem so let's take a look at some numbers for actual companies so i've got a couple so kimberly clark here and colgate palmolive um so i just felt like just in the mood for consumer products companies today i guess so uh they both make uh products like the kimberly clark makes huggies and you know some diapers and colgate palmolive colgate makes toothpaste other products so these are both consumer products companies hey and day sales outstanding day sell inventory days payable outstanding i've already calculated these okay this is for 2020 uh fiscal year and so now i went and i calculated the operating cycle and cash conversion cycle for each of these companies so we could compare them so you see you just add day sales outstanding and days to sell inventory that's 98 so basically kimberly clark it so they make let's say some paper towels okay so they make some paper towels and they're going to sell them to walmart so it takes them 55 days to sell their inventory but then 43 days to collect the cash from from walmart whoever so 98 days is their operating cycle however their days payable outstanding 94 okay 94. so basically their suppliers are providing nearly all the financing they only so they don't have to pay those suppliers until 94 days later so basically they only have to cover four days at least in 2020 right they only had to cover four days in terms of getting some short-term borrowing or something like that so basically it's like look yeah it takes us 98 days to get cash from customers but for 94 of the days we don't even have to pay the supplier so we only got to borrow to be able to cover that four days now colgate palmolive on the other hand so their operating cycle 117 days so that's to again to sell the inventory and collect the cash from customers but then when we subtract the days payable outstanding is 71. okay so we get the 117 minus 71. that's that's where i'm getting this number from i hope you got that so 46 days so they have to figure out 46 days of financing basically they're like look hey the supplier wants to be paid and we're like uh well we don't have the money from the customer yet so they have to rely on short-term borrowing or some other financing to build cover those 46 days until they get the cost from the customer