The Cash Cycle

Three activity ratiosDays on Hand, Days Sales Outstanding, and Days Payable – can be combined to demonstrate how well a company is managing its cash flow. The resulting statistic, known as the Cash Cycle, is calculated as follows:

DOH + DSO – DP = Cash Cycle.

Conceptually, the Cash Cycle measures a company’s need to finance its purchases, or the length of time between when a company spends money and the time it receives the money from selling the resulting product. Going back to the original ratios:

  • DOH measures how much inventory the company needs to have in order not to run out and miss sales. In other words, it is how long it will take to sell a particular item after receiving it.
  • Days payable measures how much time elapses between receiving the inventory and paying the supplier. So even though the company already possesses the inventory, it doesn’t have to pay for it immediately and this line is therefore a subtraction from the cash cycle.
  • DSO measures the time after the sale that the company allows its customers to pay.

In our earlier posts, we calculated the DSO and DP for Plantronics, Inc. as 50.0 and 26.8, respectively. We can also use the information provided to calculate their DOH at 71.5 days. So the cash cycle = 71.5 + 50.0 – 26.8 = 94.7 days.

So, Plantronics needs to get a component 71.5 days before it will actually sell the resulting headset. The first 26.8 days of that time, it will not yet have paid its suppliers. But that leaves 44.7 days (71.5 – 26.8) that it will have to hold inventory that has already been paid for but that has not yet been sold. Then, after making the sale it will have to wait another 50 days before it can collect the cash from its own customers. The total is 94.7 days that the company must be able to operate without the cash its operations will eventually generate.

For more information, see all articles on: Financial Statement Analysis, Fundamental Analysis, Investing in Stocks, Ratio Analysis, Security Selection

See also:
  • Normalizing Price to Earnings Ratio for Business Cycle Effects
  • Factors Affecting the Business Cycle
  • Six Stages of Business Cycle Investing
  • Stages of the Business Cycle
  • Industry Classification: Business Cycle Reaction
  • Technical Analysis Explained : The Successful Investor's Guide to Spotting Investment Trends and Turning Points

    The Intelligent Investor: The Classic Text on Value Investing

    Financial Statement Analysis: A Practitioner's Guide, 3rd Edition

    Managing Investment Portfolios: A Dynamic Process (CFA Institute Investment Series)

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