Operating Cycle Formula, Example and Calculation

Whether you are a businessman or a student, you must have come across the term “Operating cycle”. As the word suggest the operating cycle is the number of days needed by the business to get stock, sell it and get cash from its sale. The Operating Cycle has a major role in any business. It is also important to understand that every business has a different operating cycle. Before diving into the details, let us first understand what is an operating cycle.

What is the Operating Cycle?

The operating cycle is the typical amount of time needed for a company to invest its initial capital to purchase raw materials, produce products, sell those products, and then get payment from customers for those products. This helps determine how much working capital a company will require to keep up with or expand its operations.

As a result of having a very short operational cycle, a business can continue to expand while maintaining very low-profit margins. Conversely, if a company’s operating cycle is extremely long, it may have healthy profits yet still need additional funding to expand even slowly. In the case of a reseller, the operational cycle merely spans the time between the first cash outlay and the date on which the company receives payment from the consumer.

To increase stocks, cash is needed to purchase goods such as raw materials. Such supplies are converted into final goods at the factory during processing. Additionally, when such things are sold, accounts receivable are created. After that, the business receives cash from the collection of receivables, and the cycle repeats itself as depicted in the image above. It takes a few days to finish the entire cycle. The operating cycle thus depicts the period between a company’s expenditures on labour, raw materials, and other costs and its cash inflow from sales of items. It is the period between the expenditure of cash and the realisation of cash.

Each business entity’s working capital cycle may be different in length.

Importance of Operating Cycle

An Operating Cycle is important due to the following reasons:

  1. It determines a company’s efficiency- An operating cycle can tell a business owner how quickly the company can sell its inventories. A shorter cycle indicates a more efficient and successful business. It indicates that a company has enough cash in case it needs to meet its liabilities. There are many advantages of the operating cycle, one of which is that it helps the company to know its financial position. A business owner’s ability to make decisions that will benefit the firm is influenced by how well they understand the company’s operating cycle. If a business has a longer operating cycle, it means that the company will need more cash to maintain its operations.
  2. Determines Company’s Financial Position- A company’s operating cycle is influenced by a wide range of factors that affect a company’s financial position A business owner’s ability to make decisions that will benefit the firm is influenced by the company’s operating cycle.
  3. Impact on a company’s relationship with its creditors- A company’s probability of failing a debt payment increases with the length of the cycle. A company’s credit rating may be harmed, which may result in increased interest rates and fees. By determining the connection between debtors and sales, creditors and sales, and inventory and sales, the operating cycle aids in just estimating the needs of working capital.

How to calculate the Operating cycle:

Let us now understand how we can calculate the operating cycle of our business. The basic formula of the Operating Cycle is:

Operating Cycle= Inventory Period+ Accounts Receivable Period

To know the company’s efficiency, the business needs to calculate its operating cycle. By following the below-mentioned steps, you can calculate the same:

Find the Inventory Period– While calculating the operating cycle, the first thing you need to find is the company’s inventory period. An organization’s holding period for inventory is the length of time it retains its goods before selling them. Managers can evaluate liquidity using the inventory holding period as a critical performance indicator. 

It measures a company’s capacity to control its assets and how quickly it can turn them into cash or revenue. You can calculate the inventory period by the following formula:

Inventory Period=365/ Inventory Turnover

Divide the price of goods that is sold by the average goods to know the turnover. The average inventory is the average of the opening and closing stock. While the cost of products sold may be seen on the income statement of the company, this can be found on the balance sheet of the business.

Find the Accounts Receivable period– Accounts Receivables mean the amount of money that a customer owes to a company. You can calculate Accounts Receivable by the following formula:

Accounts receivable period = 365 / receivables turnover.

Now, you can calculate the operating cycle using the basic formula –

Operating cycle = inventory period + accounts receivable period,

The result will be the number of days in the company’s operating cycle.

Examples of the operating cycle

Suppose Anthony owns a restaurant and he wants to know how well operations are running at his shop. To do this, he has to calculate his company’s operating cycle. That simply means his operating cycle would start when he starts paying for goods and materials used in his restaurant. This operating cycle would not end until all of his restaurant’s goods have been sold out and he receives cash from the sales.

Similarly, suppose Kiara owns a garment shop and she needs to find her operating cycle. So, the operating cycle would start as and when Kiara starts purchasing goods and other materials for her shop and will end only when all her stock is sold and she receives cash.

Conclusion

Utilizing your efficiency based on its operations can benefit a company in many ways. The cost of things like inventory, accounts receivable, non-selling expenses (i.e., general administrative), payroll overhead, etc. can all be reduced, thanks to operational efficiency. An operational efficiency indicates that there is more money available for maximising shareholder value or corporate reinvestment.

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