In an organization, a constant movement of goods and services is carried out, elements which originally were the raw materials acquired by the company and in its finished products sold to the public.
The process that goes from the acquisition, transformation and sale of raw materials is called the financial cycle of a company, a set of actions that are perpetually repeated and the duration of which depends directly on the number of people and of activities involved.
Below we will see in more detail 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.
What is the financial cycle of a business?
The financial cycle of a business is the constant movement of goods and services that occurs within an organization so that it can continue to function. When one of these cycles is finished, it starts again.
This process ranges from the purchase of the raw material, through the conversion of some finished product or service, sale, registration to making money, which is the main goal of any business.
The financial cycle is therefore the length of time a business needs to complete all of its operationsHere is what it takes to perform your normal operation. By evaluating the financial cycle of an organization, one can have a vision of the operational efficiency of a company and, in case it is too long, the institution itself must make efforts to shorten as much as possible and obtain its economic activity. is more efficient and successful.
The shorter the financial cycle, the faster the company will be able to recover its investment. Conversely, if the financial cycle is longer, it will mean that the company will need more time to transform the raw materials that it has acquired into the goods or services that it offers allowing it to make a profit.
Corporate financial cycles tell us how many days have passed since the materials needed by the organization to make or sell goods and services were purchased, Collect the money from these sales, pay your suppliers and collect the cash. This process is useful in estimating the amount of working capital that the organization will need to maintain or develop its operation, that is, to have a minimum of profits and to realize an economic profit.
In the financial cycle, you want to have a good investment / income ratio, that is to say, invest the minimum to make money, without this implying a loss of turnover for not having stocks of materials or for not having made adequate financing. In other words, entrepreneurs are looking for the best way to make more money without investing too much. Management decisions or negotiations with business partners will affect the company’s financial cycle, making it longer or shorter.
Usually companies with a short financial cycle require less liquidity, as there are usually fewer people involved and therefore lower wages. In these cases, even if there are small profit margins, you can grow by saving and investing in better machines. On the other hand, if a business has a long financial cycle even with high profit margins, it might need additional funding to be able to grow as it needs more money to move forward because there are more. people involved, with little savings.
The financial cycle can be determined mathematically and simply by using the formula (considering a period of 12 months):
inventory period + accounts receivable period = financial cycle
Below we will see what the inventory period and the accounts receivable period are.
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 goods sold per day
Average inventory is the sum of the amount of the initial inventory at the start of the year or period plus the inventory at the end of the year or period being measured. This result is divided by 2. As for the cost of the goods, this value is obtained by dividing the total annual cost of the goods sold by 365 days of the year or the days of the period evaluated.
Accounts receivable period
The accounts receivable period is the time in days to recover cash from the sale of inventory.
Accounts receivable period = average accounts receivable / sales per day
The average accounts receivable is the sum of the total accounts receivable at the beginning of the year or period assessed plus accounts receivable at the end of that year or period, dividing the result by 2.the sales per day, they are determined by dividing the total sales by 365.
Financial cycle and net financial cycle
The net financial cycle or cash cycle tells us how long it takes for a business to recover cash from selling inventory.
Net financial cycle = financial cycle – accounts payable period
In turn, the period of accounts payable can be defined by the formula:
Accounts Payable Period = Average Accounts Payable / Cost of Goods Sold per Day
Average accounts payable are the sum of the total accounts payable at the beginning of the year or period plus the accounts payable at the end of the year or period being measured, and the result divided by 2.the cost of goods sold per day is determined in the same way as for the inventory period.
In the short and long term
As we have said, the financial cycle of a business is the time it takes to carry out its normal functioning. As defined on the basis of the time variable, this cycle must necessarily be classified into two: short or current financial cycle and long-term or non-current financial cycle.
Short term or current
The short-term or ongoing financial cycle represents the flow of funds or the operational generation of them (working capital). This type of cycle lasts depending on the amount of resources required to carry out its normal functioning. The elements that make up this cycle are the acquisition of raw materials, their conversion into finished products, their sale and the obtaining of economic gains, these phases being those which constitute the current assets and the current liabilities, which are part of the fund. rolling.
By working capital, we mean the investment made by a company in current assets: cash, marketable securities, receivables and stocks. The concept of “current” refers to the time with which the company carries out its normal operations in terms defined as commercial, which can be 30, 60, 90, 120 or 180 days, which generally coincides with its credit policy. and collection and with the conditions granted to it by its suppliers for the settlement of accounts payable.
Net working capital is defined as current assets less current liabilities, Being these latter bank loans, accounts payable and taxes accrued. A business will make profits as long as its assets exceed its liabilities, that is, it will earn more than it has to spend and pay.
The net working capital requirement allows us to make an approximate calculation of the capacity of the company to continue the normal development of its activities during a determined period in the medium and long term, generally envisaged 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 immediately converted into cash without significant loss of value. The solvency of a company is its ability to meet 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 not working
The long-term or non-current financial cycle encompasses fixed and long-term investments made to achieve company objectives, equity held in period income and long-term loans as well as financing varis. Permanent investments, such as real estate, machinery, equipment and other long-term materials and assets, gradually participate in the short-term financial cycle through depreciation, amortization and depletion.
The long-term financial cycle contributes to the short-term financial cycle by increasing working capital. The length of the long-term financial cycle is the time it takes for the business to recoup all that fixed, sustainable investment made. This cycle has been adopted to classify certain concepts that involve economic gains on a one-year view or that are above the normal cycle of short-term trading.
Among the elements that make up the long-term financial cycle are non-current assets, non-current liabilities and equity, all of which are subject to long-term reserves, contingencies and provisions. As for its indicators, we have two: debt and return on investment or return on investment.
The importance of knowing both types of financial cycles
Knowing the length of the short and long term financial cycle is very important because it allows us to:
- Classify the operations carried out by the entity among commercial or financial transactions
- Recognize and adequately measure the assets and liabilities generated by the financial instruments in which these transactions are supported.
When we talk about the financial cycle, we will always be talking about the time during which the cash flow flows through the exiting company and entering it.. In other words, it takes time for money to revert back to cash after moving through the operating activities of the business, which is part of what we call the short-term financial cycle, and / or spent on long-term investing or financing activities. term financial cycle.
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- 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. Accounting tools.