Updated July 12, 2023
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 a business takes to purchase inventory stock, convert 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 the operating cycle because it covers the entire blockage of cash in the purchase of inventories and recovery of the cash after achieving customer sales. The next cycle is started once the cycle is over, 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. The cycle can be expressed as a summation of the inventory and accounts receivable periods. Mathematically, it is represented as,
Examples of Operating Cycle
Following are examples are given as follows:
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 calculate as,
The inventory Period calculates as
Inventory Period = Average Inventory / Cost of goods sold * 365
- Inventory Period = $400,000 / $900,000 * 365
- Inventory Period = 162 days
Accounts Receivable calculates as
Accounts Receivable Period = Average Accounts Receivable / Sales * 365
- Accounts Receivable Period = $50,000 / $1,200,000 * 365
- Accounts Receivable Period = 15 days
Op. The cycle calculates as
Operating Cycle = Inventory Period + Accounts Receivable Period
- Op. Cycle = 162 days + 15 days
- Op. Cycle = 177 days
Therefore, the company’s op. The 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 per its annual report for the December 31, 2019, financial year.
| 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 calculates 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
The accounts Receivable Period calculates 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. The cycle calculates as
Operating Cycle = Inventory Period + Accounts Receivable Period
- Op. Cycle = 97 days + 71 days
- Op. Cycle = 168 days
Therefore, SDF Inc.’s op. The cycle for the year 2019 is 168 days.
Components of the Operating Cycle
The op. cycle can be broken down into two major components –
- Inventory Period
- Accounts Receivable Period
The inventory period refers to the current inventory level and the assessment of how quickly it will be converted to a finished product and sold in the market. Mathematically, it is calculated as the average inventory divided by the cost of goods sold multiplied by 365, as shown below.
Inventory Period = Average Inventory / Cost of goods sold * 365
The accounts receivable period refers to the credit sales and assessing how quickly the company can 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. The cycle can influence by the following:
- Higher-order fulfillment rates increase inventory levels, eventually leading to a longer op. Cycle. Similarly, a lower-order fulfillment rate means a shorter op. Cycle.
- Loose policies pertaining to payment collection result 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. The cycle formula is very important as it is useful in assessing a company’s operational efficiency. A shorter op. Cycle means that the company can recover its investment in inventory faster during a longer op. Cycle means that the company takes longer to transform inventory into sales and cash. A shorter op. The 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. It is represented as a summation of inventory days and accounts receivable period.
On the other hand, the net operating cycle also refers to the duration between the purchase of inventory and the collection of cash from sales. Still, it is adjusted for the time offered by the suppliers, resulting in a lower value than op. Cycle. It is represented as inventory days plus accounts receivable period minus accounts payable days.
Advantages
Some of the advantages of op. The cycle is as follows:
- Over a period of time, the trend in op. The cycle can indicate a change in the bargaining power of a company.
- It can be linked to an incentive system encouraging employees to shorten the op. Cycle.
Disadvantages
Some of the disadvantages of op. The cycle is as follows:
- Few critics believe that op. The 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 the operating cycle. You may also look at the following articles to learn more –
