Operating Cycle

What is Operating Cycle?

The term “operating cycle” refers to the duration between the time when a company purchases inventory and the time when the company realizes sales. In other words, it is the time taken by a business for purchasing inventory stock, converting it into finished goods, and then sell it in the market. The operating cycle is a very important factor in the assessment of the operational efficiency of any business.

Explanation of  Operating Cycle

The duration is known as operating cycle because it covers the entire process of blockage of cash in the purchase of inventories and recovery of the cash after achieving sales from customers. Once the cycle is over, the next cycle is started wherein that cash is used to purchase a new set of raw materials to produce more inventories and the cycle continues.

The formula for Operating Cycle

The formula for op. cycle can be expressed as a summation of the inventory period and accounts receivable period. Mathematically, it is represented as,

Operating Cycle = Inventory Period + Accounts Receivable Period

Examples of  Operating Cycle

Following are examples are given below:

Example #1

Let us take the example of the below company to compute its op. cycle for the financial year 2019 on the basis of the following information:

Particulars	Amount
Average inventory	$400,000
Average accounts receivable	$50,000
Sales	$1,200,00
Cost of goods sold	$900,000

The inventory period can be calculated as,

Inventory Period is calculated as

Inventory Period = Average Inventory / Cost of goods sold * 365

• Inventory Period = $400,000 / $900,000 * 365
• Inventory Period = 162 days

Accounts Receivable is calculated as

Accounts Receivable Period = Average Accounts Receivable / Sales * 365

• Accounts Receivable Period = $50,000 / $1,200,000 * 365
• Accounts Receivable Period = 15 days

Op. Cycle is calculated as

Operating Cycle = Inventory Period + Accounts Receivable Period

• Op. Cycle = 162 days + 15 days
• Op. Cycle = 177 days

Therefore, the company’s op. cycle for the year 2019 is 177 days.

Example #2

Let us take the example of SDF Inc. to illustrate the computation of op. cycle. The following information is available as per its annual report for the financial year that ended on December 31, 2019.

Particulars	Amount
Opening inventory	$300,000
Closing inventory	$500,000
Opening accounts receivable	$300,000
Closing accounts receivable	$400,000
Sales	$1,800,000
Cost of goods sold	$1,500,000

The inventory Period is calculated as

Inventory Period = (Opening Inventory + Closing Inventory)/2 / Cost of Goods Sold * 365

• Inventory Period = ($300,000 + $500,000)/2 / $1,500,000 * 365
• Inventory Period = 97 days

Accounts Receivable Period is calculated as

Accounts Receivable Period = (Opening Accounts Receivable + Closing Accounts Receivable)/2 / Sales * 365

• Accounts Receivable Period = ($300,000 + $400,000)/2 / $1,800,000 * 365
• Accounts Receivable Period = 71 days

Op. Cycle is calculated as

Operating Cycle = Inventory Period + Accounts Receivable Period

• Op. Cycle = 97 days + 71 days
• Op. Cycle = 168 days

Therefore, SDF Inc.’s op. cycle for the year 2019 is 168 days.

Components of Operating Cycle

The op. cycle can be broken down into two major components –

1. Inventory Period
2. Accounts Receivable Period

Inventory period: It refers to the current inventory level and the assessment of how quickly it will be converted to finished product and sold in the market. Mathematically, it is calculated as average inventory divided by cost of goods sold multiplied by 365 as shown below.

Inventory Period = Average Inventory / Cost of goods sold * 365

Accounts receivable period: It refers to the credit sales and the assessment of how quickly the company is able to recover the cash from their sales. Mathematically, it is calculated as average accounts receivable divided by sales multiplied by 365 as shown below.

Accounts Receivable Period = Average Accounts Receivable / Sales * 365

Duration of Operating Cycle

The duration of an op. cycle can be influenced by:

• Higher-order fulfillment rate results in increased inventory level, which eventually leads to a longer op. cycle. Similarly, a lower-order fulfillment rate means a shorter op. cycle.
• Loose policies pertaining to payment collection results in delayed customer payment, which prolongs the op. cycle. Stronger policies can help in shortening the op. cycle.

Importance and Uses of Operating Cycle

The concept of op. cycle formula is very important as it is useful in the assessment of an company’s operational efficiency. A shorter op. cycle means that the company is able to recover its investment in inventory faster, while a longer op. cycle means that the company takes longer to transform inventory into sales and then into cash. A shorter op. cycle is always preferable as it indicates better control of working capital management.

Operating Cycle vs Net Operating Cycle

Although most analysts use op. cycle and net op. cycle interchangeably, they are not the same and have a subtle difference. Op. cycle refers to the duration from the purchase of inventory to the collection of cash from sales and it is represented as a summation of inventory days and accounts receivable period.

Operating Cycle  =  Inventory Period + Accounts Receivable Period

On the other hand, net operating cycle also refers to the duration between the purchase of inventory and collection of cash from sales, but it is adjusted for the time offered by the suppliers and as such, it results in a lower value than op. cycle. It is represented as inventory days plus accounts receivable period minus accounts payable days.

Net Operating Cycle  =  Inventory Period + Accounts Receivable Period –  Accounts Payable Period

Advantages

Some of the advantages of op. cycle are as follows:

• Over a period of time, the trend in op. cycle can indicate a change in the bargaining power of a company.
• It can be linked to an incentive system in order to encourage employees to shorten the op. cycle.

Disadvantages

Some of the disadvantages of op. cycle are as follows:

• Few critics believe that op. cycle is not the best measure of a company’s efficiency as it merely covers the liquidity profile in terms of working capital.
• There are no defined standards for op. cycle and is subject to variation based on market conditions.

Recommended Articles

This is a guide to Operating Cycle. Here we discuss the introduction and examples along with the importance and uses of operating cycle. You may also look at the following articles to learn more –

1. Cash Conversion Cycle
2. Automation Testing Life Cycle
3. Current Asset
4. Current Liabilities Examples