From CFA text book:
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To me, they are both saying the same thing: Pay supplier --> get cash from customer. I cannot distinguish between these two terms. Can someone explain to me as simply as possible what the difference between these two terms are? I’ve read at least 5 other threads on this and still can’t tell the difference. I think the answer to my confusion lies somewhere in understanding the significance of netting out # of days payable in the Net operating cycle formula. Can anyone speak to that?
Thanks.
Perhaps the simplest way to begin understanding the two (and how they’re different) is by seeing the formulas for each:
Operating Cycle = Days of Inventory on Hand ( DOH ) + Days of (Credit) Sales Outstanding ( DSO )
…where: DOH = 365/Inventory Turnover Ratio
…where inventory turnover ratio = COGS/Avg. Inventory
and
…where: DSO = 365/Receivables Turnover
…where: Receivables Turnover = Credit Sales/Avg. Accounts Receivable.
Essentially, the Operating Cycle looks to see how long after inventory is acquired does it take for the company to see cash come through the door.
The Net Operating Cycle just takes it one step further and adds a third item to the above equation:
Net Operating Cycle (aka cash conversion cycle) = DOH + DSO - Days of Payables Outstanding ( DPO )
…where: DPO = 365/Payables Turnover
…where: Payables Turnover = Total Purchases From Suppliers/Avg. Accounts (or Trade) Payables.
Here we’re taking into the account that our supply purchases tend to be on credit, as in we don’t pay cash out immediately but rather over some period. DPO tells us how many days on average we’re taking to make payments on our purchases made on credit. So we’re subtracting this DPO figure from how long we take to collect cash (DOH + DSO) to arrive at what our net cash conversion cycle (net operating cycle) is.
Hope this helps!
Previous comment has all the right information. The diagram makes it easier to remember.
Operating Cycle = full stretch from left to right.
Net Operating Cycle = Cash Conversion Cycle = 2/3 on the right side.
