Question

Explain how the cash flow cycle works.

Answer 1

Cashflow Cycle also popularly known as Cash conversion cycle explains the time taken by a business to convert its inputs into cash. In other words it shows how much time is required to convert the investment into cash.

Typically a business invests money in raw materials, which are inturn converted to finished goods which are held as stock in trade and then sold to customers and it receives the money from customers towards goods sold. The time involved in converting the investment to cash is called as cashflow cycle. Generally, the cash flow cycle is measured in terms of days. Smaller the cycle better the business because, it provides an opportunity to effective utilization of cash for maximization of profits.

Formula to calculate Cash Flow Cycle

Cash Flow Cycle = DIO + DSO - DPO

DIO - Days Inventory Outstanding are the number of days required to sell the inventory to customers. A small DIO represents a business is able to make sales quickly without holding the stock for more period of time.

DIO = Average Inventory/Cost of Goods Sold per day

Average Inventory =(Opening Inventory + Closing Inventory)/2

DSO - Days Sales Outstanding represents the numbers of days required to collect cash from customers towards the sales. It represents how quickly the Accounts Receivable (AR) are converted into cash. If the cash is collected from customers in lesser period, it represents the Accounts Receivables are managed effectively.

DSO = Average AR/Credit Sales per day

Average AR = (Opening AR + Closing AR)/2

DPO - Days Payable Outstanding represents the number of days the business takes to pay its bills. In other words it represents the credit facility enjoyed by the business from its vendors i.e., Accounts Payables (AP). By maximizing the number of days towards paying it's vendors the company holds on more cash which it can invest in activities to earn more profit.

DPO = Average AP/ Cost of Goods Sold per day

Average AP = Opening AP + Closing AP)/2

Cash Flow Cycle is used as a barometer to measure the effectiveness of management and overall financial health of a business.