Cash Flow Cycle

The cash flow cycle of a business, also known as the cash conversion cycle, refers to the time it takes for a company to convert its investments in inventory and other resources into cash flows from sales. Understanding this cycle is crucial for managing liquidity and ensuring the business can meet its financial obligations. Here’s a breakdown of the cash flow cycle:

1. Purchase of Inventory

The cycle begins when the company purchases raw materials or goods. Cash is used to pay suppliers, and the inventory is added to the company's balance sheet.

2. Production or Preparation

If the business is involved in manufacturing, raw materials are transformed into finished goods. In a retail business, this step involves preparing the inventory for sale. During this period, money is tied up in inventory and production costs.

3. Sales

The finished goods are sold to customers. Depending on the business model, sales can be either cash sales or credit sales. For cash sales, the company immediately receives payment, adding to the cash reserves.

4. Accounts Receivable

For credit sales, the company allows customers to pay at a later date, creating accounts receivable. During this period, the company waits to receive cash from customers.

5. Collection

The company collects payments from customers who bought on credit. This process converts accounts receivable back into cash, completing the cycle.

Key Metrics in the Cash Flow Cycle

Several key metrics help in understanding and managing the cash flow cycle:

• Days Inventory Outstanding (DIO): This measures the average number of days the company holds inventory before selling it. A shorter DIO indicates efficient inventory management.

• Days Sales Outstanding (DSO): This measures the average number of days it takes to collect payment after a sale has been made. A shorter DSO indicates faster collection of receivables.

• Days Payable Outstanding (DPO): This measures the average number of days the company takes to pay its suppliers. A longer DPO means the company retains cash longer, which can improve cash flow but may affect supplier relationships.

• Cash Conversion Cycle (CCC): The CCC is calculated as DIO + DSO - DPO. It represents the net number of days it takes for a company to convert its inventory and other resources into cash flows from sales. A shorter CCC indicates a more efficient cash flow cycle.

Importance of Managing the Cash Flow Cycle

• Liquidity: Efficient management of the cash flow cycle ensures the company has enough cash to meet its short-term obligations and invest in operations.

• Profitability: By reducing the time inventory sits in storage and speeding up receivables collection, companies can lower costs and increase profitability.

• Supplier Relationships: Managing the DPO is crucial for maintaining good relationships with suppliers while optimising cash flow.

• Operational Efficiency: A well-managed cash flow cycle indicates effective operational processes, from inventory management to sales and collections.

Example of a Cash Flow Cycle

1. Inventory Purchase: A company buys £10,000 worth of inventory, paying cash.

2. Production/Sales: The inventory is used to produce goods, which are sold for £15,000 on credit.

3. Accounts Receivable: The £15,000 is recorded as accounts receivable.

4. Collection: After 30 days, the company collects the £15,000 from customers, converting receivables back into cash.

The company initially outlays £10,000, generates £15,000 in sales, and finally collects £15,000 in cash, completing the cash flow cycle. By analysing the time taken at each stage, the company can identify areas for improvement to shorten the cycle and enhance liquidity.

Understanding and optimising the cash flow cycle helps businesses maintain sufficient cash flow, support growth, and ensure long-term financial health.