What Inflation Concerns Teach Us About Business Operating Cycle

It’s the summer of 2021, and prices on many goods and services are increasing. Businesses are paying more for raw materials, and qualified workers hard to find. It’s getting more expensive to produce products and services, and firms are under pressure to increase prices.

 

Two questions may keep business owners up at night:

 

• Can I produce a product or service and still earn a profit at current prices?
• Will I generate enough cash inflows to pay the higher prices for materials and labor?

 

Inflation is defined as the overall increase in prices over time, and inflation has an impact on each component of the operating cycle. As the name implies, the operating cycle defines how quickly you can make a product (or purchase inventory), sell the product, and collect cash.

 

Let’s walk though each component of the operating cycle, so you can use this metric to make informed business decisions.

 

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Using the turnover ratios

 

Collecting cash faster is the name of the game, and the turnover ratios measure how quickly you collect cash. For many businesses, the biggest uses of cash are accounts receivable and inventory:

 

• Accounts receivable: When you sell goods on credit, you don’t recoup the cost of your product until the customers pays for the purchase
• Inventory: In a similar way, you don’t recoup the cost of inventory until the customer invoice is paid

 

Accounts Receivable Turnover Ratio = (Credit sales) / (Average gross accounts receivable)

 

“Average” refers to the average balance in a month or year. Let’s assume annual credit sales of $1,200,000, and average gross accounts receivable of $350,000 for the year.

 

($1,200,000 Credit sales) / ($350,000 Average gross accounts receivable) = 3.43

 

On average, the company sells the entire accounts receivable balance about 3.4 times per year. You want to increase sales and reduce accounts receivable, so that the turnover rate is higher, and you collect cash faster.

 

If you can’t raise prices and costs are increasing, you need to collect accounts receivable balances even faster- in order to finance operations.

 

Inventory turnover views cash collections from the cost of sales side of things. Here is the formula:

 

 

Inventory Turnover = (Cost of goods sold) / (Average inventory)

 

Assume that the turnover ratio looks like this:

 

($900,000 Cost of goods sold) / ($125,000 Average inventory) = 7.2

 

The company sells the entire inventory balance about seven times per year.

 

Whether these turnover ratios are good or bad depends on your industry, and you should compare your performance to industry averages.

 

Inflation forces up the cost of inventory, which leads to a higher cost of goods sold balance. If you can’t raise prices, you’ll make a smaller profit.

 

Working with the days sales ratios

 

It’s helpful to assess your business by measuring days. Again, getting financial results faster is better in this context.

 

Day sales in inventory = (365) / (Inventory turnover)

 

This ratio converts inventory turnover (how often do you sell your entire inventory balance in a year) into a number of days. Here’s the days sales total:

 

(365) / (7.2 Inventory turnover) = 50.69

 

It takes about 51 days to completely sell the inventory balance.

 

Day sales outstanding in receivables = (365) / (Accounts receivable turnover)

 

Ok- similar formula for account receivable. The days sales total is below:

 

(365) / (Accounts receivable turnover) = 106.46

 

To collect the average accounts receivable balance, the company needs about 106 days.

 

Putting it all together: the operating cycle

 

So how long does it take you to sell inventory and collect accounts receivable? That’s the operating cycle:

 

Operating cycle = (50.69 Day sales in inventory) + (106.46 Day sales outstanding in receivables) = 157.15

 

You need 157 days, on average, to sell all of your inventory once, and collect the accounts receivable balances once. Is that good or bad? It depends on your industry.

 

Inflation can reduce your profits and create a cash squeeze in your business. Use the operating cycle formulas to improve your business.

 

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Ken Boyd

Author: Cost Accounting for Dummies, Accounting All-In-One for Dummies, The CPA Exam for Dummies and 1,001 Accounting Questions for Dummies

(email) ken@stltest.net

(website and blog) https://www.accountingaccidentally.com/

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