B- Cash cycle

Often the analysis of liquidity starts with the calculation of the current ratio. But, the current ratio (as many other ratios) depends a great deal on the nature of the industry and the type of company under study. The starting point proposed in the present work is to look at different industry types. Six industries are chosen to illustrate that the need for liquid assets is different. Liquidity needs depend on the operating or cash cycle of each type of firm. This is the movement of circulating cash or working capital (i.e. liquid resources) through the productive cycle, from initial outlay for raw material to collection of proceeds from sales.

Some of the cycles are very short (e.g. the shortest being probably a bettor's with the bookmaker at a race track), and some are very long (e.g. the breading of elephants can take more than one human generation). All start with spending cash for purchases of supplies to which salaries of production workers are added to convert raw materials into finished goods, which, in turn, generate sales leading to accounts receivable which result in payments that go back into cash balance. The length of the cash cycle of a firm can be estimated by combining the time inventory remains unsold measured by Days Sales in Inventory (DSI), plus the time it takes for clients to pay measured by Days Sales Outstanding (DSO), less the time suppliers allow the firm not to pay measured by Days Purchases Outstanding (DPO). Table T-8.2 below presents the length of cash cycles of six US industries (calculated in 1993), as well as several liquidity ratios.

 Table T-8.2 Selected ratios for six US industries in 1993 . G M W R U S Current ratio 2.6 1.7 1.4 1.1 1.4 1 Quick Ratio 1.3 0.8 0.9 0.5 1.2 1 DSO (days) 43 55 41 3 51 9 DSI (days) 89 70 26 14 - - DPO (days) 45 29 27 12 - - Cash cycle (days) 91 96 40 5 51 9 NWC 36% 26% 27% 5% 9% -2% G = Manufacturers in growth industry - Drugs and Medicines, SIC 2833 M = Manufacturers in cyclical industry - Machinery, SIC 3561 W = Wholesalers - Furniture, SIC 5021 R = Retailers - Grocery food Stores, SIC 5411 U = Telephone Communication, SIC 4812 S = Services - Travel Agencies, SIC 4724 Source: Robert Morris Associates, "Annual Statements Studies, 1994"

Before starting on an interpretation of the numbers in Table T-8.2 it is necessary to comment on the data itself first. The cash cycle estimate is somewhat defective for manufacturing firms that require, in addition, a period of time for production, and whose raw materials and work-in-progress inventories is understated when compared to sales. As will be seen below, this distortion does not seem to interfere with the thrust of conclusions drawn from statistics. Let's take a look at how the structure of the balance sheet is affected by cash cycles in these six different industries.

The choice of industries was guided by the desire to show ratios of companies with very different strategies and needs. (By contrast, average ratios of entire sectors are far less different, as can be observed in table Table T-8.4, Median ratios of 80,000 US firms in eight sectors in 1999.) To avoid aggregation of disparate companies, only one company size group was chosen: the one with the least dispersion. Moreover, all industries had to have a sufficient number of companies in the sample (i.e. no less than 10) for that group size. Among the six size groups available, the size that turned out to be most suitable was the group of companies with sales from \$10 to \$25 million, which is the second behind the largest size group with sales of over \$25 millions. It will be pointed out later that small firms tend to experience wide variation in performance. Whereas large firms often have product lines that belong to several other industries. The choice of mid-size companies seems therefore most appropriate.

Now let us draw some conclusions from the data presented. From Table T-8.2, it can be observed that manufacturing has naturally (and in spite of the noted known understatement of inventories) much longer cash cycles than any other industry: pharmaceuticals need 91 days and machine manufacturers 96. Food stores have the shortest cash cycle of 5 days notwithstanding the large inventory they carry (25% of total assets). Service industries have short cash cycles as can be expected, with just 9 days for travel agencies. But telephone companies give their clients much time to pay, resulting in a rather long cash cycle of 51 days. Wholesalers use receivables more than any other industry in the sample (indeed receivables represent 45% of total assets); yet, their cash cycle is barely 40 days because they manage to use the credit given to them by the furniture manufacturers to finance their inventory holding (in fact, payables are outstanding 27 days which is strangely longer than the average the inventory is held, 26 days).

 In 1995, Russian retail firms held very large working capital representing 96% of total assets (whereas in the U.S. the same retail industry had only 45% of its assets in working capital). Surprisingly, more than a third of working capital consisted of cash ( 35%) notwithstanding the fact that holding cash is very expensive in time of high inflation. Apparently, Russian firms maintained such large cash balances because of the high probability of business failures due to extremely unstable economic conditions.

See review questions Q-8B.1 through Q-8B.9.

See research assignments R-8B.1 through R-8B.3.