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

Let's see what the financial cycle of a company is, its characteristics and phases.

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

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

We will now take a closer look at the definition of a company's financial cycle, its characteristics, periods and calculations within this concept, and what its characteristics are. within this concept and what are its short and long term modalities.

What is the financial cycle of a company?

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

This process ranges from the purchase of raw materials, through the conversion of certain finished products or services, the sale, the file to the earning of money, which is the main objective of any company.

Thus, the financial cycle is the period of time that it takes for a company to carry out all its operationsThis is the time it takes to carry out its normal operation. By evaluating the financial cycle of an organization, it is possible to have an insight into the operational efficiency of a company and, if it is too long, the institution itself should make efforts to shorten it as much as possible and make its economic activity a more efficient and successful business.

The shorter the financial cycle, the sooner the company will be able to 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 it has acquired into the goods or services it offers and which allow it to make a profit.

Characteristics

The financial cycles of companies tell us how many days pass from the time the materials needed for the organization to manufacture or sell goods and services are purchasedThe financial cycles of companies tell us how many days pass from the time the organization purchases the materials necessary for it to manufacture or sell goods and services, collects the cash from those sales, pays its suppliers, and gets the cash back. This process is useful to estimate the amount of working capital that the organization will need to maintain or grow its operation, that is, to have a minimum profit and make economic profit.

In the financial cycle, the aim is to have a good investment-earnings ratio, i.e., to invest just enough to make money, without this implying the loss of sales due to not having a stock of materials or not having made adequate financing. In other words, entrepreneurs look for the best way to obtain more profit without investing too much. Management decisions or negotiations with business partners will affect the company's financial cycle, making it either longer or shorter.

Typically, companies with 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, growth can be achieved 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 may require additional financing to grow because it needs more money to keep going as there are more people involved, with little savings.

The financial cycle can be determined mathematically and simply by 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 that inventory remains in storage after it has been produced.. This can be understood by the following formula:

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

The average inventory is the sum of the amount of beginning inventory 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. For cost of goods, this value is obtained by dividing the total annual cost of goods sold by 365 days of the year or days of the period being evaluated.

Accounts receivable period

The accounts receivable period is the length of time in days to recover cash from the sale of inventory..

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 period under evaluation plus accounts receivable at the end of that year or period, divided by 2. Sales per day are determined by dividing total sales 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 cash from the sale of inventory..

Net financial cycle = financial cycle - accounts payable period.

In turn, the accounts payable period can be defined by the following formula:

Accounts payable period = average accounts payable / cost of goods sold per day

The average accounts payable is 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 measured, the result being divided by 2. The cost of goods sold per day is determined in the same way as for the inventory period.

Short and long term

As mentioned above, the financial cycle of a company is the time it takes to carry out its normal operations. As it is defined on the basis of 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 the operational generation of funds (working capital).. This type of cycle lasts according to 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 the obtaining of economic profits, these being the phases that constitute current assets and current liabilities, which are part of working capital.

Working capital refers to a company's investment 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 terms defined as commercial, which may be 30, 60, 90, 120 or 180 days, normally coinciding with its credit and collection policy and with the terms granted by its suppliers for the settlement of accounts payable.

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

Net working capital allows us to make an approximate calculation of the company's capacity to continue with the normal development of its activities during a specific period of time in the medium and long term, being usually looked at for the next twelve months.

The indicators provided by the short-term financial cycle are twofold: 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 its capacity to meet its debts and its ability to pay, i.e. it is a ratio between what the company has and what it owes.

Long-term or non-current

The long-term or non-current financial cycle comprises fixed and long-lasting investments made to meet business objectives, and equity held in the results of the period and long-term loans as well as miscellaneous financing. other. Permanent investments, such as real estate, machinery, equipment and other materials and long-term assets gradually participate in the short-term financial cycle through depreciation, amortization and depletion.

The long-term financial cycle helps the short-term financial cycle by increasing working capital. The duration of the long-term financial cycle is the time it takes for the company to recover all the fixed and lasting investment made. This cycle has been adopted to classify certain concepts that involve economic gains more than one year ahead or is longer than the normal cycle of short-term operations.

Among the elements that make up the long-term financial cycle are non-current assets, non-current liabilities and equity, minus reserves, contingencies and long-term provisions. As for its indicators, we have two: indebtedness and return on investment or return on investment..

The importance of knowing both types of financial cycles

It is of great importance 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 adequately measure the assets and liabilities generated by the financial instruments in which such transactions are supported.

When we talk about the financial cycle, we are always talking about the time in which cash flows in and out of the company.. In other words, it is the time it takes for money to be converted back into cash after going through the company's operating activities, which are within what we call the short-term financial cycle, and/or going through investment or financing activities, which are in the long-term financial cycle.

Bibliographical 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.