Chapter 29 Financial Planning 765
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assets have different degrees of risk and liquidity. You can’t pay bills with inventory or with
receivables. You must pay with cash.
The Cash Cycle
Think about the regular financing that Dynamic needs in order to maintain regular operations.
The company conducts a very simple business. It buys raw materials for cash, processes them
into finished goods, and then sells these goods on credit. The whole cycle of operations looks
like this:
CashReceivablesFinished goodsRaw materialsThe delay between Dynamic’s initial investment in inventories and the final sale date is
called the inventory period (a measure that should be familiar to you from Chapter 28). The
delay between the time that the goods are sold and when the customers finally pay their bills
is the accounts receivable period (another measure that should be familiar). The total length
of time from the purchase of raw materials until the final payment by the customer is termed
the operating cycle:
Operating cycle = inventory period + accounts receivable periodDynamic is not out of cash, however, for this entire cycle of operations. Although the
company starts by purchasing raw materials, it does not pay for them immediately. The longer
that it defers payment, the shorter the time that the firm is out of cash. The interval between
the firm’s payment for its raw materials and the collection of payment from the customer is
known as the cash cycle or cash conversion period:
Cash cycle = operating cycle − accounts payable period
= (inventory period + accounts receivable period) − accounts payable periodThis is illustrated in Figure 29.3.
◗ FIGURE 29.3
Operating and
cash cycles.Raw materials
purchasedPayment for
raw materialsSale of
finished goodsCash collected
on salesAccounts
receivable
periodAccounts payable
periodInventory periodOperating cycleCash conversion cycle