What is the Operating Cycle?

We must begin by asking, "what is accounting?"  Arguably developed by Babylonians and popularized by the Italians, accrual accounting is a method of measuring accretions to wealth.  While this may be useful for evaluating the acquisition of stock or an entire business, it is useless for operating a business on a daily basis.  If a business operator wants to make payroll by Friday and loan payments by the end of the month, he manages to cash flows, not wealth.  The expression, "a day late and a dollar short" refers to cash, not wealth, and its hundreds-year-old etymology is testimony to its universal truth.

Conduct of business can be classified into two asset conversion cycles: operating and capital. 

Capital conversion involves capturing the return on investment from long-lived assets such as land, plant and equipment.  Simple capital-budgeting tools such as net-present-value calculations give us almost instant decision criteria for evaluating these long-term investments, and such are not of much concern in daily operations.

The operating asset conversion cycle is of absolute relevance to the going concern of the enterprise. 

The conversion of:

accounts payable 

to raw materials inventory

to wages payable

to inventory for sale

to sales

to accounts receivable

to cash...

is the lifeblood of any business, and is the banker's creed.

Using the old trick of days-on-hand calculations, the length of the cash-to-cash operating cycle can be defined as inventory-holding-period plus the accounts receivable-holding-period less the payables-period.

The question becomes, how to manage the multivariable, cross-purpose incentives to each, such as:

• Short-term investment rates v. interest rate on lines of credit

• Quantity discount v. inventory holding costs

• Early payment discounts v. borrowing rates

• Collection costs v. investment rates

Baker, Jake & Powell can study your operations and provide you with a custom  algorithm (adjustable to changing circumstances) which can minimize your investment in your operating cycle and line of credit usage, and maximize your cash flow to meet your financial obligations.

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