How much liquidity a fi rm needs depends on its operating cycle. The operating cycle is the duration from the time cash is invested in goods and services to the time that investment produces cash. For example, a fi rm that produces and sells goods has an operating cycle comprising four phases:

• Purchase raw materials and produce goods, investing in inventory.
  
• Sell goods, generating sales, which may or may not be for cash.
  
• Extend credit, creating accounts receivable.
  
• Collect accounts receivable, generating cash.

The four phases make up the cycle of cash use and generation. The operating cycle would be somewhat different for companies that produce services rather than goods, but the idea is the same—the operating cycle is the length of time it takes to generate cash through the investment of cash.
What does the operating cycle have to do with liquidity? The longer the operating cycle, the more current assets are needed (relative to current liabilities) since it takes longer to convert inventories and receivables into cash. In other words, the longer the operating cycle, the greater the amount of net working capital required.
To measure the length of an operating cycle we need to know:
The time it takes to convert the investment in inventory into sales (that is, cash → inventory → sales → accounts receivable).
The time it takes to collect sales on credit (that is, accounts receivable → cash).
We can estimate the operating cycle for Fictitious Corporation for the current year, using the balance sheet and income statement data. The number of days Fictitious ties up funds in inventory is determined by the total amount of money represented in inventory and the average day’s cost of goods sold. The current investment in inventory—that is, the money “tied up” in inventory—is the ending balance of inventory on the balance sheet. The average day’s cost of goods sold is the cost of goods sold on an average day in the year, which can be estimated by dividing the cost of goods sold (which is found on the income statement) by the number of days in the year.
The average day’s cost of goods sold for the current year is

In other words, Fictitious incurs, on average, a cost of producing goods sold of $17,808 per day.
Fictitious has $1.8 million of inventory on hand at the end of the year. How many days’ worth of goods sold is this? One way to look at this is to imagine that Fictitious stopped buying more raw materials and just fi nished producing whatever was on hand in inventory, using available raw materials and work-in-process. How long would it take Fictitious to run out of inventory?
We compute the days sales in inventory (DSI), also known as the number of days of inventory, by calculating the ratio of the amount of inventory on hand (in dollars) to the average day’s cost of goods sold (in dollars per day):

In other words, Fictitious has approximately 101 days of goods on hand at the end of the current year. If sales continued at the same price, it would take Fictitious 101 days to run out of inventory.
If the ending inventory is representative of the inventory throughout the year, then it takes about 101 days to convert the investment in inventory into sold goods. Why worry about whether the year-end inventory is representative of inventory at any day throughout the year? Well, if inventory at the end of the fi scal year-end is lower than on any other day of the year, we have understated the DSI. Indeed, in practice most companies try to choose fi scal year-ends that coincide with the slow period of their business. That means the ending balance of inventory would be lower than the typical daily inventory of the year. To get a better picture of the fi rm, we could, for example, look at quarterly fi nancial statements and take averages of quarterly inventory balances. However, here for simplicity we make a note of the problem of representatives and deal with it later in the discussion of fi nancial ratios.
It should be noted that as an attempt to make the inventory fi gure more representative, some suggest taking the average of the beginning and ending inventory amounts. This does nothing to remedy the representativeness problem because the beginning inventory is simply the ending inventory from the previous year and, like the ending value from the current year, is measured at the low point of the operating cycle. A preferred method, if data is available, is to calculate the average inventory for the four quarters of the fi scal year.
We can extend the same logic for calculating the number of days between a sale—when an account receivable is created—and the time it is collected in cash. If we assume that Fictitious sells all goods on credit, we can fi rst calculate the average credit sales per day and then fi gure out how many days’ worth of credit sales are represented by the ending balance of receivables.
The average credit sales per day are

Therefore, Fictitious generates $27,397 of credit sales per day. With an ending balance of accounts receivable of $600,000, the days sales outstanding (DSO), also known as the number of days of credit, in this ending balance is calculated by taking the ratio of the balance in the accounts receivable account to the credit sales per day:

If the ending balance of receivables at the end of the year is representative of the receivables on any day throughout the year, then it takes, on average, approximately 22 days to collect the accounts receivable. In other words, it takes 22 days for a sale to become cash.
Using what we have determined for the inventory cycle and cash cycle, we see that for Fictitious

We also need to look at the liabilities on the balance sheet to see how long it takes a fi rm to pay its short-term obligations. We can apply the same logic to accounts payable as we did to accounts receivable and inventories. How long does it take a fi rm, on average, to go from creating a payable (buying on credit) to paying for it in cash?
First, we need to determine the amount of an average day’s purchases on credit. If we assume all the Fictitious purchases are made on credit, then the total purchases for the year would be the cost of goods sold less any amounts included in cost of goods sold that are not purchases. For example, depreciation is included in the cost of goods sold yet is not a purchase. Since we do not have a breakdown on the company’s cost of goods sold showing how much was paid for in cash and how much was on credit, let us assume for simplicity that purchases are equal to cost of goods sold less depreciation. The average day’s purchases then become

The days payables outstanding (DPO), also known as the number of days of purchases, represented in the ending balance in accounts payable is calculated as the ratio of the balance in the accounts payable account to the average day’s purchases:

For Fictitious in the current year,

This means that on average Fictitious takes 33 days to pay out cash for a purchase.
The operating cycle tells us how long it takes to convert an investment in cash back into cash (by way of inventory and accounts receivable). The number of days of payables tells us how long it takes to pay on purchases made to create the inventory. If we put these two pieces of information together, we can see how long, on net, we tie up cash. The difference between the operating cycle and the number of days of purchases is the cash conversion cycle (CCC), also known as the net operating cycle:

Or, substituting for the operating cycle,

The cash conversion cycle for Fictitious in the current year is

The CCC is how long it takes for the fi rm to get cash back from its investments in inventory and accounts receivable, considering that purchases may be made on credit. By not paying for purchases immediately (that is, using trade credit), the fi rm reduces its liquidity needs. Therefore, the longer the net operating cycle, the greater the required liquidity.