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Cash can also enter the cycle by way of loans or equities. And it leaves to repay loans, buy capital assets or pay dividends.
The Cash Cycle: The cycle of investing cash in resources, providing goods or services to customers using those resources
and collecting cash from customers is called the cash cycle.
Cash Lag: The delay between the expenditure of cash and the receipt of cash collected
o Cash lag varies from business to business and is determined by various factors such as; average
inventory/service turnover time, debtor days and creditor days
Inventory Conversion Period: Average length of time between receiving inventory from a supplier and selling it to a
customer
Payables Deferral Period: Average number of days between receipt of goods or services from a supplier to payment
of the supplier
Receivables Conversion period: Average length of time between delivery of goods to a customer and receipt of cash
collected
Inventory Self-Financing Period: Average number of days between the date inventory is paid for by the entity and
the date it's paid for by a customer
Important Notes on Cash Cycles:
Cash and net income can be drastically different
Cash lag and the cash cycle are important concepts for understanding cash/liquidity positions of businesses
Internal and external circumstances can affect an entity's liquidity
2. Cash from Investing Activities: Cash spent on buying capital assets and other long-term assets and the cash received
from selling those assets. Activities include;
3. Cash from Financing Activities: Cash raised from and paid to owners and lenders. Activities include;
Two types of adjustments can be made when reconciling CFO using the indirect method:
1. The first method removes all transactions and economic events that are included in the calculation of net income but
do not affect cash flow. (i.e. depreciation expense, which is subtracted in the calculation of net income, will need to
be added back to net income to find CFO.) When a non-cash item is subtracted when calculating net income it must
be added back to reconciling from net income to CFO and vice versa for non-cash items that are added when
calculating net income.
2. Second method adjusts revenues and expenses so only cash flows are reflected. When using the indirect method,
increases in working capital asset accounts such as accounts receivable, inventory, and prepaids are subtracted from
net income, and decreases are added back. Increases in working capital liability accounts such as accounts payable,
wages payable, and accrued liabilities are added to net income, and decreases are subtracted. When revenues and
expenses are recorded at different times than the associated cash flows, the difference appears on the balance sheet
as a non-cash working capital item.
a. Example: When cash from a credit sale (previously allocated to AR and recognized as revenue) is collected, AR
decreases but there is no income statement effect.
i.
ii.
b. Example: When wages are expensed and paid for the year.
i.
ii.
SUMMARY:
Liquidity: A short-term concept that refers to the availability of cash or the ability to convert assets to cash. Important
assessment tool to evaluate how well an entity can meet its current obligations. (ex. of liquid assets: cash, shares, AR. Nonliquid assets: Land, buildings, equipment, intangibles)
Solvency: An entity's viability in the long-term, ability to pay its long-term debts. Entities are insolvent if they have liabilities
greater than its assets, or if they cannot pay their debts as they come due.
Other Issues
Operating Cash Flow Ratio: Since the Current Ratio is static and only based on balance sheet items, liquidity can often be
better evaluated by using the Operating Cash Flow Ratio. OCR that`s less than 1.0 may mean that the entity is unable to
meet its short-term responsibilities.
Free Cash Flow: The available cash after capital expenditures have been made. It is available for the acquisition of new
companies, expansion, debt reduction, or share purchase.