The definition of the operating cycle is the amount of time a Company needs to convert inventory to accounts receivable, and accounts receivable to cash, offset by the amount of payables that can be maintained.
Day AR + Days Inventory – Days AP
Everyone learns how to calculate the operating cycle in lending school or from their accounting text books. The operating cycle is often calculated for a loan approval memo.
But, the operating cycle is much more than a simple calculation. It is a view into how a Company manages its working capital, and how suppliers and customers are interacting with the Company. Companies in the same sector operate with quite a variety of vendor and customer relationships, and different management approaches to differentiate on service and products.
Working capital management is the key to survival for every business. Negotiations and relationships tying to accounts receivable have impacts on what a Company is able to accept from vendors and accounts payable, as well as inventory management. For some companies, unique aspects related to one component impact how the company is able to deal with other components. For example, if customers pay quickly to garner discounts, the company is able to more quickly pay accounts payable, or have higher levels of inventory.
How to approach the operating cycle
Our method of analysis makes an adjustment to the standard calculation to improve the understanding of the operating cycle.
Calculate the days sales invested in accounts receivable, inventory and accounts payable. Use sales rather than cost of goods sold to focus on the number of days sales invested, and to eliminate differences in how a company records cost of goods sold year over year.
With this change, the operating cycle tells how many days sales are invested in working capital components key to an asset based lending relationship.
The table below shows the operating cycle for a Company over three years, plus a forecast.
Of note, this Company provided a forecast for 2020 but did not provide a cash flow forecast. Balance sheet forecasts are often single page forecasts based on averages, year end balances, or other calculated values. Without a roll forward of accounts receivable, inventory, accounts payable, cash and the line of credit, the simplistic approach to balance sheet forecasting may disguise problems.
One way to test the balance sheet forecast is to consider the operating cycle components, in conjunction with the forecast line of credit balance.
Using the same turnover in 2020 as occurred in 2019, the cash invested in the operating cycle changes from $24.4 million to $31.9 million, for an increased cash need of $7.5 million.
Looking at this increased need for cash by working capital component, the proposed improvement in accounts receivable collections provides $2.8 million of cash, the proposed improvement in inventory provides $4.8 million in cash and the payables turnover is essentially unchanged.
The proposed changes in the operating cycle have material impact on the cash needs of the business.
Accounts Receivable:
Changing from a 70-day receivable turnover to a 59-day receivable turnover means the Company will either have to change payment terms with its customers or change how it manages its receivable collection process and retrain its customers. Both of those options are difficult to implement. There may be contracts with customers that cannot change overnight. There may be standards of dealing that are firmly entrenched. Customer concentrations may limit the ability of a borrower to change the receivables turnover as the risk of losing customers is too great.
The lender will need to ask pointed detailed questions to determine how this forecast improvement in accounts receivable turnover could occur.
Inventory:
Changing from an 83-day inventory turnover to a 64-days inventory turnover means the Company will need to reduce its investment in inventory. This is difficult to accomplish as companies tend to accumulate slow moving inventory over time, and the inventory that is easily sold is moving through the sales process quickly. Most computer systems today allow a company to generate an inventory aging. That is a key aging report that is often omitted from the information request list a lender generates. Supply chain issues can occur based on regulatory situations, strikes at ports, trucking staffing issues, and health scares such as experienced with the coronavirus.
The lender will need to know how the Company expects to deal with its supply chain, and how it evaluates its inventory aging and turnover.
Accounts Payable:
While changes in the payable turnover are not forecast in this example, the Company is forecasting its sales to increase from $80 million in 2019 to $95 million in 2020. A $15 million increase in revenues will require suppliers to allow additional amounts on trade lines of credit. If this additional funding is not provided by the trade, the lender may be asked to fund an additional amounts – 30 days of $15 million of increased sales requires $500,000. If there is heavy reliance on a few vendors, the ability to stretch payment terms may be lessened. If inventory needs are uncertain, the company may need to pay faster for inventory to be at the top of the line at the suppliers.
The lender will need to understand trade lines of credit, payment terms, and reliance on vendors. The lender will also need to evaluate check writing processes to make sure that accounts payable are not understated because checks have been written but have not been mailed.
Operating Cycle:
As a lender, numbers like operating cycle seem obscure digits on a page. Looking behind the numbers at the financial impact, such as the $7.5 million increase in working capital noted above, or the changes in relationships with supplier and customers or inventory management, it is clear those obscure digits are difficult for a company to manage. A company that does not pay attention to each of these components of working capital is at more risk of performance problems.
Cash and the Line of Credit:
A change in working capital management on the accounts receivable, inventory and accounts payable side of the business directly affects cash balances and the line of credit. In a quickly prepared or high-level balance sheet forecast it is easy to use cash or line of credit as a plug number. That is an additional risk for the lender. Using the line of credit as the balancing number does not forecast availability tied to accounts receivable, inventory and accounts payable. Forecasting that line of credit availability using roll forwards and increasing scrutiny on forecasts for ineligibles shows whether the asset base on the working capital management are sufficient to support the line of credit.
Summary
When a lender or financial advisor works with a company on its cash management, understanding the components of working capital is key. Getting behind the numbers and understanding vendor payment terms and vendor lines of credit, inventory ordering processes and the inventory aging, and customer contracts and payment terms are just a few of the critical considerations. When a company says this approach is too detailed, that may mean the company does not understand how serious these working capital management decisions are to survival.
For example, forecasting cash receipts in the first thirteen weeks of a cash flow requires use of the detailed accounts receivable aging – a company cannot collect what it has not billed. Also for example, accounts payable cannot be forecast based on monthly sales levels, but rather based on what is outstanding in the accounts payable aging. Companies that have been slow paying vendors may not be able to bring inventory in as timely as required to support customer needs. A cash flow forecast, in its initial weeks, must be anchored in the reality of current working capital components. Then the forecast must move into the analysis of operating cycle trends with the backdrop of what could reasonably be changed. When diving into working capital management, attention must be paid to forecasting and managing working capital – the operating cycle is an important clue in this analysis.
If you have a borrower that could benefit from a working capital review and cash management process, please call us. We are ready to jump in and help.