FINANCIAL CYCLE OF A COMPANY: CHARACTERISTICS - DUDAS - 2025

The financial cycle of a company is the constant movement of products or services that takes place so that the company can continue to operate. Once the cycle is completed, it starts again. It covers the purchase of raw material, its conversion into finished products, the sale, the file (if it is an account receivable) and the acquisition of money.

Therefore, it is the period of time that a company takes to carry out its normal operation (purchase, manufacture, sale and return of money). The financial cycle offers a vision of the operational efficiency of a company; This cycle is intended to be as short as possible to make the business more efficient and successful.

Therefore, a shorter cycle indicates that a company will be able to recoup its investment quickly and that it has enough cash to meet its obligations. If the financial cycle is long, it indicates that it takes more time for a company to convert its inventory purchases into cash.

characteristics

- The financial cycle of a company indicates how many days it takes to buy the materials necessary to manufacture and sell the goods or services, collect the cash from that sale, pay the suppliers and get the cash back. It is useful for estimating the amount of working capital that a company will need to maintain or grow its operation.

- In the financial cycle, the maximum reduction in the investment of inventories and accounts receivable is sought, without this involving loss of sales due to not having stocks of materials or not providing financing.

- Management decisions or negotiations with business partners affect the financial cycle of a company.

- A company with a short financial cycle requires less cash to maintain its operations; it could grow even by selling on small margins.

- If a company has a long financial cycle, even with high margins it may require additional financing to grow.

- The financial cycle is determined in this way (taking a 12-month period): inventory period + accounts receivable period = financial cycle

Inventory period

The inventory period is the number of days that inventory is in storage.

Inventory period = average inventory / cost of merchandise sold per day.

Average inventory is the sum of the amount in beginning inventory for the year (or prior year end) plus inventory at the end of the year, available on the balance sheet. This result is divided by 2.

The cost of merchandise sold per day is obtained by dividing the total annual cost of merchandise sold, available in the income statement, by 365 (days per year).

Accounts receivable period

The accounts receivable period is the duration in days to collect the cash from the inventory sale.

Accounts Receivable Period x = Average Accounts Receivable / Sales per Day

Average accounts receivable is the sum of the amount of accounts receivable at the beginning of the year plus accounts receivable at the end of the year. This result is divided by 2.

Sales per day are determined by dividing the total sale, available in the annual income statement, by 365.

Financial cycle and net financial cycle

The net financial cycle or cash cycle indicates how long it takes for a business to collect cash from the sale of inventory.

Net financial cycle = financial cycle - accounts payable period

Where:

Accounts Payable Period = Average Accounts Payable / Cost of Merchandise Sold per Day.

Average accounts payable is the sum of the amount of accounts payable at the beginning of the year plus accounts payable at the end of the year. This result is divided by 2. The cost of merchandise sold per day is determined the same as for the inventory period.

The following image illustrates the financial cycle of a company:

Short term

The short-term financial cycle represents the flow of funds or the operational generation of funds (working capital). The duration of this cycle is related to the amount of resources required to perform the operation.

The elements that make up this cycle (acquisition of raw materials, conversion of them into finished products, their sale and collection) constitute current assets and current liabilities, which are part of working capital.

The current concept refers to the time in which the company carries out its normal operations within the defined commercial terms.

Working capital is a company's investment in current assets (cash, marketable securities, accounts receivable, and inventories).

Net working capital is defined as current assets minus current liabilities, the latter being bank loans, accounts payable and accrued taxes.

As long as the assets exceed the liabilities, the company will have net working capital. This measures the capacity of the company to continue with the normal development of its activities in the next twelve months.

Indicators

The indicators provided by the short-term financial cycle are liquidity and solvency. Liquidity represents the quality of assets to be converted into cash immediately.

The solvency of a company is its financial capacity to meet its obligations that expire in the short term and the resources it has to meet these obligations.

Long-term

The long-term financial cycle includes the fixed and durable investments made to meet business objectives, as well as the existing equity in the results of the period and long-term loans.

Permanent investments, such as real estate, machinery, equipment, and other long-term assets, gradually participate in the short-term financial cycle through their depreciation and amortization. Thus, the long-term financial cycle helps the short-term financial cycle by increasing working capital.

The length of the long-term financial cycle is the time it takes for the company to recoup that investment.

Indicators

Among the indicators provided by the long-term financial cycle, debt and return on investment stand out.

When talking about the financial cycle, we will always be referring to the time in which cash flows through the company, as cash outflows and cash inflows.

That is, it is the time it takes for money to be converted back into cash, after going through the company's operating activities (short-term financial cycle) and / or going through investment or financing activities (financial cycle long-term).

References

1. Boston Commercial Services Pty Ltd. (2017). What is a “Financial Cycle” and How does it Affect your Business? Taken from: bostoncommercialservices.com.au.
2. Steven Bragg (2017). The operating cycle of a business. AccountingTools. Taken from: accountingtools.com.
3. CFI - Corporate Finance Institute (2018). Operating cycle. Taken from: corporatefinanceinstitute.com.
4. Magi Marquez (2015). Importance of calculating the financial cycle in companies. Accountant counted. Taken from: countercontado.com.
5. Hector Ochoa (2011). How to determine the financial cycle of your business. Consulting & Comprehensive Consulting Service. Taken from: aysconsultores.com.
6. Investopedia (2018). Operating Performance Ratios: Operating Cycle. Taken from: investopedia.com