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Operating and Cash Cycle for Financial Management and Policy Mcom Sem 2 Delhi University

Operating and Cash Cycle for Financial Management and Policy Mcom Sem 2 Delhi University

Operating and Cash Cycle for Financial Management and Policy Mcom Sem 2 Delhi University

Operating and Cash Cycle for Financial Management and Policy MCOM Sem 2 Delhi University :  Capital required for the business can be of two types: 1. Fixed Capital 2. Working Capital Fixed capital is required to create the production facilities through purchase of fixed assets like Land, Machinery, and Building etc. Investment in these assets represents that part of firm’s capital, which is blocked on permanent or fixed basis and is called fixed capital. Funds are also needed for short-term purpose for the purchase of Raw material, Payment of Wages etc. these funds are known as Working Capital. In simple words, working capital refers to that part of firm’s capital, which is required for financing short-term assets. 

Operating and Cash Cycle for Financial Management and Policy Mcom Sem 2 Delhi University

(A)On the basis of concept

(i) Gross working capital concept: According to this concept, working capital means total of all current assets of business.. Gross working capital = Total current assets.

(ii) Net working capital concept: According to this concept, working capital means excess of current assets over current liabilities. Net Working capital = Current Assets – current Liabilities As per the general practice net working capital is referred to simply as working capital.

Operating and Cash Cycle for Financial Management and Policy Mcom Sem 2 Delhi University

(B) On the basis of time

(i) Fixed or permanent working capital: There is always a minimum level of current assets which is continuously required by the enterprise to carry out normal business operation. For ex. Every firm has to maintain a minimum level of stock and cash balance. This minimum level of current assets is called fixed working capital as this amount is permanently blocked in currant assets

(ii) Temporary or variable working capital. It is that amount of working capital which is required to meet the seasonal demand and some special needs. Any amount over and above the permanent level of working capital is called as Temporary or variable working capital.

This cycle of raw material conversion to cash is called operating or working capital cycle. In terms of time, it is the time taken after the purchases of raw material till its translation into cash. The total of inventory holding period and a receivable collection period of a firm is the operating cycle time of that firm.

Operating cycle and cash operating cycle are used interchangeably but it’s a misconception. They are different by a small margin but that makes a big difference.

Operating and Cash Cycle for Financial Management and Policy Mcom Sem 2 Delhi University

Operating Cycle / Need for Working Capial

Every business needs some amount of working capital. The need for working capital arises due to the time gap between the production and realization of cash from sales. Thus working capital is needed for the following purposes:

1. For the purchase of raw material, components and spares parts.

2. To pay wages and salaries

3. To incur day-to-day expenses.

4. To meet the selling costs s packing, advertising.

5. To provide the credit facilities to the customers.

6. To maintain the inventories of Raw material, work in progress, finished stock There is an operating cycle involved in the sales and realization of cash.

Operating and Cash Cycle for Financial Management and Policy Mcom Sem 2 Delhi University

The cycle starts with the purchase of raw material and ends with the realization of cash from sales of finished foods. It involves purchase of raw material and stores, it conversion in to stock of finished goods through work-in- progress, conversion of finished stock in to sales, debtors and receivables and ultimately in cash and this cycle continues again from cash to purchase of raw material and so on.

The gross operating cycle of the firm = RMCP +WIPCP + FGCP+RCP Where, RMCP = Raw material conversion period WIPCP = Work in progress conversion period FGCP = Finished goods conversion period RCP = Receivables conversion period

However a firm may acquire some resources of credit and thus defer payments fro certain period. In this case Net operating cycle period = Gross operating cycle period – Payable deferral period. 

Operating and Cash Cycle for Financial Management and Policy Mcom Sem 2 Delhi University

Cash Operating Cycle and its Importance

Like working capital, operating cycle can also be gross operating cycle (operating cycle) and net operating cycle (cash operating cycle). Cash operating cycle is gross operating cycle less creditor’s collection period. It is the time period for which the working capital is required.

The time of operating cycle can be broken as follows:

1. Inventory Holding Period

• Raw Material Holding Period

• Work-in-process Period

• Finished Goods Holding Period

2. Receivables Collection Period

Operating and Cash Cycle for Financial Management and Policy Mcom Sem 2 Delhi University

Formula for Operating Cycle

Operating Cycle = Inventory Holding Period + Receivable Collection Period

Or, Operating Cycle = Raw Material Holding Period + Work-in-process Period + Finished Goods Holding Period + Receivable Collection Period

Formula for Cash Operating Cycle

Cash Operating Cycle = Inventory Holding Period + Receivable Collection Period – Creditor’s Payment Period

Or, Cash Operating Cycle = Raw Material Holding Period + Work-in-process Period
+ Finished Goods Holding Period + Receivable Collection Period – Creditor’s Payment Period

Operating and Cash Cycle for Financial Management and Policy Mcom Sem 2 Delhi University

Operating Cycle Example

Suppose $500 Dollar worth of inventory is purchased from a supplier on 20 days credit and it was sold after 40 days of purchasing it. The credit of 40 days is given to the buyer.

The buyer paid on completion of the credit period.

Here,
The Operating Cycle = Inventory Holding Period + Receivable Collection Period
= 40 + 40
= 80 Days.

Cash Operating Cycle = 80 Days – 20 Days (Supplier’s Credit)
= 60 Days.

Operating and Cash Cycle for Financial Management and Policy Mcom Sem 2 Delhi University

Importance of Operating and Cash Cycle

Operating cycle is extremely important because business is all about the running the operating cycle smoothly. If it is running smoothly, almost everything will be smooth. If any part of the operating cycle is stuck, the whole business gets disturbed. For a manager to effectively manage the business, he should have a deep understanding of his business cycle and potential threats and risks to it. Proactively, he should have ways and means to mitigate those threats and risks.

In our example, operating cycle is 80 days. The entrepreneur should always focus to reduce it as more as possible and that will ensure better utilization of their fixed assets. In turn, they will gain the higher return on their investment.

On the other hand, cash operating cycle is the base for working capital estimations. In our example, working capital requirement is $500 for 60 days. Banks take this as a base for funding their client. A manager handling finance should focus on reducing the cash cycle as that will save him the interest cost. Reducing this cycle means reducing the inventory holding period and increasing the supplier’s payment period. Other than normal strategies, Japanese techniques ‘Just-in-Time (JIT)’ can reduce the inventory holding time practically zero. Bigger companies are trying to adopt JIT with the help of tools like supplier system integration etc. 

Operating and Cash Cycle for Financial Management and Policy Mcom Sem 2 Delhi University

Factors Determining Working Capital Requirements

The working capital requirement of a concern depends upon a large number of factors, which are as follow:

1. Nature or Character of Business: Public utility undertakings like Electricity, Water supply and Railways need very limited working capital because they offer cash sales only and supply services not products. On the other hand, Trading and Financial firms require less investment in fixed assets but have to investment large amount in current assets like inventories, receivables etc.

2. Size of Business: Greater the size of business unit, generally larger will be the requirement of working capital. In some case even a smaller concern need more working capital due to high overhead charges, inefficient use of resources etc.

3. Production Policy: The production could be kept either steady by accumulating inventories during slack periods with a view to meet high demand during the peak season or the production could be curtailed during the slack season and increased during peak season. If the policy is to keep the production steady by accumulating inventories it will require higher working capital.

4. Seasonal Variations: In certain industries, raw material; is not available throughout year. They have to buy raw material in bulk during the season to ensure an uninterrupted flow and process them during the entire year. A huge amount is blocked in the form of material inventories during such season, which give rise to more working capital.

5. Working Capital Cycle: In manufacturing concern, the working capital cycle starts with the purchase of raw material and ends with the realization of cash from the sales of finished products. This cycle involves purchase of raw material and starts, its conversion into stock of finished goods through work in progress with progressive increment of labor and service costs, conversion of finished stock into sales, Debtor and receivables and ultimately realization of cash and this cycle continues again from cash to purchase of raw material so on.

6. Rate of Stock Turnover: There is high degree of inverse co relationship between the quantum of working capital and the velocity or speed with which the sales are affected. A firm with having a high rate of stock turnover will need lower amount of working capital as compared to the firm having a low rate of turnover.

7. Credit Policy: A concern that purchases its requirement on credits and sells its products / services on cash require lesser amount of working capital. On the other hand, concern buying its requirement for cash and allow credit to its customers, will need larger amount of working capital as very huge amount of funds are bound to be tied up in debtors or bills receivables.

8. Business Cycle: Business Cycle refers to alternate expansion and contraction in general business activity. In period of boom i.e. when the business is prosperous, there is need for larger amount of working capital due to increase in sales, rise in prices, and expansion of business. On the contrary in the times of depression i.e., when there is down swing of cycle, the business contracts, sales decline, difficulties are faced in collection from debtors and firms may have a large amount of working capital lying idle.

9. Rate of Growth of Business: For the fast growing concern, larger amount of working capital is required. 

Operating and Cash Cycle for Financial Management and Policy Mcom Sem 2 Delhi University

Importance or Advantages of Adequate Working Capital

Working capital is the lifeblood and nerve center of a business. No business can run successfully without and adequate amount of working capital.

The main advantage of maintaining adequate amount of working capital is as follow:

1. Solvency of the business: Adequate amount of working capital helps in marinating solvency of business by providing uninterrupted flow of production.

2. Goodwill: sufficient amount of working capital enables business concern to make the prompt payment and helps in creating and marinating goodwill.

3. Easy Loans: a concern having adequate amount of working capital, high solvency and credit standing can arranges loans from banks.

4. Cash Discounts: Adequate amount of working capital also enables a concern to avail cash discounts on the purchases and hence it reduces the costs.

5. Exploitation of favorable market condition: Adequate amount of working capital enables a concern to exploit favorable market conditions such as purchasing its requirement in bulk when the prices are lower and by holding its inventories for higher prices.

6. Ability to face the crises: Adequate amount of working capital enables a concern to face the business crises in emergencies such as depression because during such periods, generally there is much pressure on working capital.

7. Quick and regular return on investments: Adequate amount of working capital enables a concern pay quick and regular dividends to its investors as there may not be much pressure to plough back profits.

8. Regular supply of raw material: Adequate amount of working capital ensures regular supply of raw material and continuous production.

Operating and Cash Cycle for Financial Management and Policy Mcom Sem 2 Delhi University

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