Tracking and operating cycles over time is a fantastic method to see how a business is doing financially. It can also aid in determining its efficiency and how smoothly activities run. Though the net operating cycle of a firm varies depending on the industry, knowing its operating cycle is useful when comparing it to other companies in the same industry.
Furthermore, the operating cycle may eventually affect whether or not an investor becomes interested in the company. This article will explain what an operating cycle is and why it is important, as well as how to calculate it using the formula, suggestions and examples.
What is an Operating Cycle?
The operating cycle is the time it takes a corporation to buy items, sell them, and receive income from the sale of these goods. In other words, it is the time it takes for a corporation to convert its inventories into cash. The length of an operating cycle varies according to the industry. Understanding a company’s operating cycle can assist assess its financial health by predicting whether or not it will be able to pay off any creditors.
For example, if a business has a short operating cycle, it indicates it will get payments at a consistent pace. The sooner the company makes cash, the more quickly it will be able to pay off any outstanding obligations or expand its business.
The following is the flow of a cash operating cycle:
- Getting raw materials
- Making products
- Having completed items
- Having receivables as a result of a sale
- Obtaining funds (receiving payment from customers)
It’s also critical to distinguish between an operating cycle and a cash cycle. While both are useful and provide vital knowledge, a cash cycle allows businesses to understand how well they manage cash flow, whereas an operating cycle determines the efficiency of the operation.
Importance of the Operating Cycle
The operating cycle is significant because it may notify a business owner how quickly they can sell an inventory. Simply, it determines the efficiency of the organization. For example, if its operating cycle is short, it suggests the company was able to execute a speedy turnaround. It could also imply that it has shorter payment terms and a more stringent credit policy.
A shorter operating cycle is preferable since it indicates that the company has sufficient cash to sustain operations, recover investments, and satisfy other obligations. In contrast, a longer operating cycle indicates that the company requires more cash to maintain operations.
As there are numerous impacts on a company’s operating cycle, there are numerous ways in which an operating cycle can aid in determining a company’s financial status. The better a business owner knows the company’s operating cycle, the better decisions that owner may make for the benefit of the business.
How to Calculate an Operating Cycle
Business owners must calculate their operating cycle in order to measure a company’s efficiency. To perform this computation, follow these steps:
#1. Establish the inventory period
When estimating the operating cycle of a business, the owner must first determine its inventory period. An inventory period is the amount of time a corporation keeps its goods before selling them. You can calculate the inventory period using the formula:
Inventory period = 365 / inventory turnover
Divide the cost of products sold by the average inventory to calculate a company’s inventory turnover. The average inventory is the sum of a company’s opening and closing inventories. This is shown on the company’s balance sheet, whereas the cost of products sold is shown on the income statement.
#2. Determine the company’s receivables.
In order to calculate the operating cycle, business owners must also know their accounts receivable. Accounts receivable refers to the amount of money owed by a customer to a business. It can be calculated in the following way:
accounts receivable period = 365 / receivables turnover
Divide credit sales by average accounts receivable to calculate a company’s receivables turnover.
#3. Calculate the operating cycle
The operating cycle can be calculated using the following formula:
operating cycle = inventory period + accounts receivable period
This operating cycle formula can also be used:
operating cycle = (365 / (cost of goods sold / average inventory)) + (365 / (credit sales / average accounts receivable))
The resulting figure represents the number of days in the company’s operating cycle.
Tips for reducing a company’s operating cycle
Here are a few pointers to keep in mind when aiming to shorten a company’s operating cycle:
- Implement a stronger credit policy: If a company has a stricter credit policy, customers are more likely to pay for their purchases on time.
- Reduce payment terms: The faster a company can collect accounts receivables, the shorter its operating cycle is likely to be.
- Sell inventory quickly: The faster a company sells its goods, the shorter its operating cycle should be.
All of the following elements influence the duration of the operating cycle and cash cycle:
- The payment terms that the company’s suppliers have offered to it. Longer payment periods reduce the operating cycle since the corporation can postpone cash payments.
- The order fulfillment procedure. Because a greater expected beginning fulfillment rate increases the amount of inventory on hand, the operating cycle lengthens.
- The credit policy and the payment terms that go with it. Because looser credit means a longer period until clients pay, the operating cycle is extended.
Typically, management decisions can have an impact on a business’s operating cycle. As a result, it is critical for any business to understand its operating cycle so that it can forecast how much working capital they need or is on hand at any one time.
If your operating cycle is too protracted, you may need more working capital to meet your existing obligations.
Operating Cycle Examples
It is necessary to explore several scenarios in order to comprehend operating cycles. Here are some examples of operating cycles:
Example #1
Assume Cindy owns a clothing store. When she started paying for the supplies to produce various clothes, her company’s operating cycle would begin. In this example, the operating cycle would not be complete until all clothing items were created, sold, and cash was received from various consumers.
Example #2
Assume Bob operates a bakery and is attempting to determine how well his business is performing. To accomplish so, he’ll need to calculate his company’s operating cycle. This means that the cycle would begin when he started paying for the commodities, resources, and ingredients used to manufacture various pastries and baked items. His bakery’s operating cycle would not be complete until all of his baked items were sold to consumers and he got payment for his sales.
Applications of the Operating Cycle Formula
Calculating the operating cycle assists management in understanding the cash inflow and cash outflow condition in connection to inventory in and inventory out. The above operating cycle formula can be used to derive the relationship between Debtors, Creditors, and Cash with Purchase and Distribution. The fundamental data obtained from the Operating Cycle formula is the number of days it takes the company to convert raw materials into cash.
Debtor’s exceptional days are frequently regarded as one of the most important indicators for analyzing product demand and the importance of a specific product in comparison to its contemporaries. The cash is not collected immediately in a credit sale; rather, it is received according to the arrangement negotiated with the distributors or retail outlets. They usually pay quickly when there is a high demand for the product from the consumer, and vice versa.
Inventory days are also an indicator of stock movement inside the organization. Every business desires a reduction in debtors’ days. It signifies that the products are capable of meeting the needs of the clients and that distributors are churning the items more frequently than the industry, which is also a positive indicator of stronger demand for the specific product in its category.
Operating Cycle vs. Net Operating Cycle (Cash Cycle)
The net operating cycle (NOC) is frequently mistaken with the operating cycle (OC). The NOC, also known as the cash conversion cycle or cash cycle, measures how long it takes a corporation to collect cash from inventory sales. To distinguish between the two:
The time elapsed between the purchase of goods and the receipt of cash from the sale of inventory is referred to as the operating cycle.
The period it takes between paying for inventory and receiving cash from the sale of inventory is the net operating cycle.
Furthermore, the Net operating cycle formula is as follows:
Inventory Period + Accounts Receivable Period – Accounts Payable Period = Net Operating Cycle
The difference between the two calculations is that NOC subtracts the accounts payable period from the first. This is done because the NOC is only concerned with the period between paying for merchandise and receiving payment from its sale.
Operating Cycle (Gross vs. Net)
The gross operating cycle (GOC) is the time elapsed between the procurement of raw materials and their conversion to cash. The time can be divided into two parts based on the gross operating formula: inventory holding period and receivables collecting period. The inventory holding duration, in this case, includes the raw material holding period, the work-in-process period, and the finished goods holding period.
GOC = Receivables Collection Period + Inventory Holding Period
Alternatively, Gross OC = Raw Material Holding Period + Work-In-Process Period + Finished Goods Holding Period + Receivables Collection Period.
The net operating cycle (NOC) is the time between paying for inventory and receiving cash from the sale of receivables. It is sometimes referred to as the Cash Conversion Cycle (CCC)
- NOC = Gross Cycle-Creditor’s Payment Period
- The NOC is thought to be a more rational method because payables are viewed as a source of operating cash or an operating cycle in the company’s working capital.
Conclusion
The operating cycle in working capital is an indicator of management efficiency. The longer a company’s cash cycle, the greater its working capital requirement. As a result, enterprises estimate their working capital requirements and commercial banks fund them depending on the duration of the Cash cycle. Reducing the cash cycle helps to free up cash, which improves profitability. Extending payment terms to suppliers, maintaining optimal inventory levels, accelerating manufacturing workflow, controlling order fulfilment, and streamlining the accounts receivables process can all help to reduce the cash cycle.
