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for a company that sells a product the company's operating cycle is the amount
of time that elapses from when the company buys the inventory until when
the company collects the cash from selling that inventory the length of the
operating cycle is the sum of the length of two very different processes first
how long from when a company buys the inventory until it sells or uses that
inventory second how long from when a company makes a sale until the company
collects the cash from that sale let's talk about that first length of time
which is often called the number of days sales and inventory let me illustrate
with an example nike makes athletic shoes and other sportswear nike
manufactures these items and then sells them to retail outlets typically on
credit in terms of the length of Nikes operating cycle we must first consider
how many days elapse from the time that Nike buys raw materials until the time
that Nike sells the finished shoes and sports work to retail outlets using data
from Nikes financial reports it can be computed that this is about 80 days this
is called the number of days sales and inventory we must then determine how
long until Nike collects the cash from these sales to retail outlets on average
this is about 50 days we call this the average collection period if you take
these two numbers and add them together 80 days from purchase of raw materials
to the sale of the finished goods and sportswear and then 50 days from the
sale to the cash collection you get a hundred and thirty days that's the
length of Nikes operating cycle again the operating cycle is the time from the
purchase of the raw materials to the collection of the cash from the sale of
the finished goods for Nike that's a hundred and thirty days when Nike
purchases its raw materials on credit from its suppliers Nike pays those bills
off in about 40 days so Nike buys raw materials on credit and then pays for
those raw materials after about 40 days but Nike doesn't collect the cash from
selling the finished shoes and sportswear until a total of 130 days
have passed this is why companies such as Nike must carefully manage purchases
sales and cash collections in order to balance out this mismatch between the
timing of cash payments and the timing of cash collections if Nike wishes to
manage operating cash flow the company has
three dials it can turn first one is the number of days sales in inventory in a
manufacturing company such as Nike reducing the number of days sales and
inventory involves streamlining the production process to get materials
through the process as quickly as possible the longer it takes to make the
shoes after buying the materials then the longer Nike has to wait until
collecting the cash from the sale of the shoes second dial average collection
period if Nike allows its customers the retail stores to delay paying for their
purchases that means that Nike must borrow cash in order to pay its own
bills while waiting for the customer cash there is a fine balance here
balancing the desire to collect the cash with a desire to please the customer by
not pestering for cash payment too quickly the third dial is the number of
days purchases in accounts payable managing operating cash flow sometimes
means stretching out the time when you pay your suppliers again this is a
balancing act if you can stretch out this time which average is 40 days for
Nike then you are preserving your cash to pay for other things however you
don't want to anger your suppliers by keeping them waiting too long if we put
all the numbers together it takes Nike a hundred and thirty days to convert
purchased raw materials into operating cash collections 80 days to make and
sell the product and 50 days to collect the cash in the meantime Nike pays for
those raw materials in about 40 days so for 90 days the difference between 130
days and 40 days Nike has to use cash from other sources to keep its operation
going of course in a steady state Nike and other companies can use cash
collected from prior sales to pay for the materials purchased to make goods
for future sales but in a growing business where cash payments to make
goods for future sales are greater than cash collected from past sales this
operating cycle mismatch can create large operating cash flow shortfalls now
to see a different operating cash flow pattern let's talk about the cash
operating cycle at McDonald's I love the cash flow pattern of McDonald's from the
time that McDonald's buys raw materials food and packaging until McDonald's
sells the finished product the rapped in the packaging about seven days
elapsed cash collection takes about two seconds because even when the customer
uses a credit or debit card McDonald's gets its electronic cash
almost instantly so the length of McDonald's operating cycle is seven days
plus two seconds seven days from the purchase of the raw materials until the
sale and then two more seconds to collect the cash now if McDonald's pays
its suppliers under standard credit terms McDonald's will pay for the food
and packaging in about 30 days so for 23 days 30 days minus the seven days in two
seconds McDonald's has the cash before needing to pay its own suppliers this
means that with this pattern of operating cash flows McDonald's or
another company with a similar pattern could grow as fast as it wanted with the
operating cycle itself providing all the cash to finance the operating growth
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capital expenditures our purchases of long-term operating assets such as land
buildings and equipment these assets are required to be used over the course of
several years in the statement of cash flows we classify the purchase of these
assets as investing activities the value of long-term operating assets stems from
the fact that they help companies generate future cash flows capital
budgeting is the name given to the process whereby decisions are made about
acquiring long-term operating assets there are several financial models used
to make capital budgeting decisions a simple one is called payback period and
involves computing how many years it will take to recover the initial
investment cost net present value or NPV analysis involves comparing the cost of
the asset with the value of the expected cash inflows after adjusting for the
time value of money the value of a long-term operating asset can disappear
instantly if events lower expectations about the future cash flows the asset
can generate these computations are very interesting but are beyond the scope of
this course capital budgeting decisions such as the
purchase of operating assets or the purchase of another company are
basically cash flow decisions the company gives up a certain amount of
cash flows today the purchase price and in the future operating outlays in the
hope of receiving a greater amount of cash flows in the future as the asset
generates revenues and/or produces cost savings to illustrate a simple capital
budgeting decision assume that yosef manufacturing makes joysticks and other
computer game accessories Yosef is considering expanding its operations by
buying an additional production facility the cost of the new factory is a hundred
million dollars this is an investing activity Yosef expects to be able to
sell the joysticks and other items made in the factory for 80 million dollars
per year at that level of production the annual cost of operating the factory the
wages the insurance the materials the maintenance and so forth is expected to
total 65 million dollars the factory is expected to remain in operation for
about 20 years should Yosef buy this new factory for a
hundred million dollars that's an investing activity decision to summarize
Yosef must decide whether to pay a hundred million dollars for a fact
that will generate a net cash inflow of fifteen million dollars per year the 80
million inflow and the 65 million outflow for 20 years now one simple
method that can be used to analyze this purchase is called the payback method or
the payback period the payback period is just the time it takes for the company
to recover its original investment calculated by dividing the original
investment cost by the net annual cash inflows received from the investment in
the case of the factory purchased being considered by Yosef manufacturing the
payback period is six point six seven years computed as follows the payback
period is the initial investment divided by the annual inflow that's a hundred
million dollars divided by fifteen million dollars per year that's six
point six seven years that's how long it takes Yosef to get its money back one
way to use this payback period number is to invest only in assets that pay back
within a certain period of time perhaps within five or six years this required
payback period might be set differently for different types of assets in
addition qualitative factors such as strategic positioning for future
expansion and potential positive motivational effects on employees would
influence the decision the important concept to remember here is that long
term operating assets have value because they are expected to help a company
generate cash flows in the future if events occur to change this expectation
concerning those future cash flows then the value of the asset changes for
example if consumer demand for computer joysticks dries up the value of a
factory built to produce joysticks can plunge overnight even though the factory
itself is still as productive as it ever was in addition to analysis of whether a
certain investing activity cash investment is a good idea a manager must
also assess the timing of the investment to fit current cash management needs
some of the questions that need to be addressed are as follows is current cash
flow from operating activities or through financing activities such as
borrowing sufficient to pay for an attractive investing activity this year
if not should the acquisition of the land building or equipment be delayed
until next year it is often efficient to acquire land
buildings and equipment in amounts a bit larger than you need immediately knowing
that you will grow into them in future years this can be better than expanding
your productive capacity a little bit each year for example so our current
cash flow is sufficient to pay for a large amount of investing activities
this year you see that managing investing cash flow requires you to
think about your current operating and financing cash flows a company's cash is
a unifying element that links all aspects of a business operating
investing and financing
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the two sources of cash from financing activities are borrowing and owner
investment the most desirable sequence of decision-making with respect to cash
from financing activities is as follows forecast the level of activity such as
the level of sales evaluate the amount of cash that will be generated from or
consumed by operating activities after a careful capital budgeting process
determined the amount of cash that will be needed for investing activities and
finally if financing cash inflows are needed compare the relative cost of
obtaining cash from borrowing and cash from owner investment as a general
statement the interest rate cost of borrowing money is lower than the cost
of giving up ownership of part of the company in exchange for new partner
investment or new shareholder investment the exact decision this year of whether
it's best to obtain financing cash inflow from borrowing or from owner
investment depends on market conditions this year detailed consideration of
these decisions is part of the field of finance an important cash outflow from
financing activities is the payment of cash dividends a key question in the
field of corporate finance is why do companies pay cash dividends and if I
could answer this question I'd get a nobel prize in economics but what we do
observe is the following most established companies pay dividends
companies are reluctant to increased events they want to make sure that
they'll be able to permanently sustain any increased level of dividends cutting
dividends is viewed as very bad news and finally dividends seem to be used to
give the illusion of stability if companies can get investors and
potential investors to focus on their steady dividends rather than their
volatile net income then the companies look much less risky it's the illusion
of stability in terms of managing financing cash flows it is very
important for a company to manage its relationships with providers of
financing lenders current investors and potential future investors
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