Financial cycle of a company: what is it, periods and calculations

In an organization there is a constant movement of goods and services, elements that in an origin were the raw materials acquired by the company and ultimately products sold to the public.

The process that goes from when raw materials are acquired, transformed and sold is called the financial cycle of a company, a set of actions that is repeated in perpetuity and whose duration depends directly on the number of people and activities that are in it involved.

Next we will see in more depth the definition of the financial cycle of a company, its characteristics, periods and calculations within this concept and what are its short and long term modalities.

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What is the financial cycle of a company?

The financial cycle of a company is the constant movement of goods and services that occurs within an organization so that it can continue to operate. When one of these cycles is completed, it starts again.

This process ranges from the purchase of the raw material, through its conversion of certain products or finished services, the sale, the file until the profit of money, which is the main objective of any business.

Thus, the financial cycle is the period of time it takes for a company to carry out all its operations, this is how long it takes to perform its normal operation. Evaluating the financial cycle of an organization can have a vision of the operational efficiency of a company and, if it is too long, the own institution should make efforts to shorten it as much as possible and ensure that its economic activity involves a business that is more efficient and successful.

The shorter the financial cycle, the sooner the company can recover its investment. On the other hand, if the financial cycle is longer, it will mean that the company will need more time to transform the raw materials that you have acquired into the goods or services that you offer and that allow you to obtain Profits.

Characteristics

The financial cycles of companies They tell us how many days pass since the necessary materials are purchased so that the organization can manufacture or sell goods and services, collect the cash from those sales, pay your suppliers and get the cash back. This process is useful for estimating the amount of working capital that the organization will need to maintain or grow your operation, that is, to have a minimum profit and profit economic.

In the financial cycle you want to have a good investment-earnings ratio, that is, you want to invest just enough to earn money, without this implying the loss of sales due to not having stocks of materials or not having made adequate financing. That is, entrepreneurs are looking for the best way to get more profit without investing too much. Management decisions or negotiations with business partners will affect the financial cycle of the company, making it either longer or shorter.

Usually, companies that have a short financial cycle require less cash, since there are usually fewer people involved and, therefore, fewer salaries. In these cases, even if there are small profit margins, you can grow either by saving and investing in better machinery. On the other hand, if a company has a long financial cycle, even with high profit margins, it might require additional financing to grow since you need more money to keep going as more people are involved, having little saving.

The financial cycle can be determined mathematically and easily using the following formula (considering a 12-month period):

inventory period + accounts receivable period = financial cycle

Next we will see what the inventory period and the accounts receivable period are.

Inventory period

We can define the inventory period as the number of days inventory remains in storage after it has been produced. This can be understood with the following formula:

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

Average inventory is the sum of the starting inventory quantity at the beginning of the year or time period to be measured plus the inventory at the end of the year or time period measured. This result is divided by 2. Regarding the cost of merchandise, this value is obtained by dividing the total annual cost of merchandise sold by 365 days of the year or the days of the evaluated period.

Accounts receivable period

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

Accounts Receivable Period = Average Accounts Receivable / Sales per Day

Average accounts receivable is the sum of total accounts receivable at the beginning of the year or evaluated period plus accounts receivable when that year or period ends, dividing the result between 2. As for the sales per day, these are determined by dividing the total sale by 365.

Financial cycle and net financial cycle

The net financial cycle or cash cycle tells us how long it takes a company to recover the cash from the sale of inventory.

Net financial cycle = financial cycle - accounts payable period

At the same time, the accounts payable period can be defined by the following formula:

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

The average accounts payable is the sum of the total accounts payable at the beginning of the year or period plus accounts payable at the end of the year or period measured, the result being divided by 2. The cost of merchandise sold per day is determined in the same way as for the inventory period.

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Short and long term

As we said, the financial cycle of a company is the time it takes to carry out its normal operation. As it is defined based on the time variable, this cycle must necessarily be classified into two: short-term or current financial cycle and long-term or non-current financial cycle.

Short term or current

The short-term or current financial cycle represents the flow of funds or their operating generation (working capital). This type of cycle lasts depending on the amount of resources required to carry out its normal operation. The elements that make up this cycle are the acquisition of raw materials, their conversion into finished products, their sale and obtaining economic gains, these phases being the ones that constitute current assets and current liabilities, which are part of the capital of job.

With working capital we refer to the investment that a company makes in current assets: cash, marketable securities, accounts receivable and inventories. The concept "current" refers to the time with which the company carries out its normal operations within the periods defined as commercial, which may well be 30, 60, 90, 120 or 180 days, normally coinciding with your credit and collection policy and with the terms granted by your suppliers for the settlement of accounts for to pay.

Net working capital is defined as current assets minus current liabilities, the latter being bank loans, accounts payable and accumulated taxes. A company will make a profit as long as the assets exceed the liabilities, that is, it earns more than it has to spend and pay.

Net working capital allows us to make a rough estimate of the company's ability to continue normal development of its activities during a specific period of time in the medium and long term, usually being viewed for the next twelve months.

There are two indicators provided by the short-term financial cycle: liquidity and solvency.. Liquidity represents the quality of assets to be converted into cash immediately without significant loss of value. The solvency of a company is the ability it has to deal with the debts incurred and its ability to pay, that is, it is a relationship between what the company has and what it owes.

Long-term or non-current

The long-term or non-current financial cycle includes the fixed and lasting investments made to meet the business objectives, and the equity that is had in the results of the period and long-term loans as well as financing various. Permanent investments, such as real estate, machines, equipment, and other materials and long-term assets term gradually participate in the short-term financial cycle through their depreciation, amortization and exhaustion.

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 recover all that fixed and durable investment made. This cycle has been adopted to classify certain concepts that imply economic gains more than one year from now or is greater than the normal cycle of short-term operations.

Among the elements that make up the long-term financial cycle we have non-current assets, non-current liabilities. current and equity and all this is deducted from reserves, contingencies and long-term provisions term. As for its indicators we have two: indebtedness and profitability on investments or return on investment.

The importance of knowing both types of financial cycles

It is very important to know the duration of the financial cycle in the short and long term, since it allows us to:

• Classify the operations carried out by the entity between commercial or financial transactions
• Recognize and properly measure the assets and liabilities generated by the financial instruments in which these transactions are supported.

When talking about the financial cycle, we will always be talking about the time in which cash flows through the company leaving and entering it. That is, it is the time it takes for money to be converted back into cash after having gone through the operational activities of the company, which are within of what we call short-term financial cycle, and / or going through investment or financing activities, which are in the long-term financial cycle.

Bibliographic references:

• Groth, John. (1992). The Operating Cycle: Risk, Return and Opportunities. Management Decision - Manage Decision. 30. 10.1108/00251749210014725.
• Boston Commercial Services Pty Ltd. (2017). What is a “Financial Cycle” and How does it Affect your Business?
• Steven Bragg (2017). The operating cycle of a business. AccountingTools.