Operating Cycle

Operating Cycle – an activity ratio measuring the amount of time needed by a firm to turn its inventories into cash. In other words, the company's operating cycle is a period between a purchase of inventories and obtaining money for sold goods or provided services (money received both from sales and from the accounts receivable collection). For instance, a shop has bought some clothing and then has sold it to customers for cash. Relatively short period between the purchase of the clothing and its sale reflects a short operating cycle. Unlike the firm that is buying raw materials, organizes the production process and then offers goods to customers with a deferment of payment. As a result, the operating cycle for the clothing manufacturing company lasts much longer than for the reseller. There are industries, for which this period exceeds a year, for example, ships manufacturing. It is also reasonable to chose similar-sized companies for the comparison, for example, the ones that possess similar amounts of assets.

This indicator can be computed by summing the inventory turnover (days) and the accounts receivable turnover (days). For the company it is desirable to observe the decrease of the operating cycle during the analyzed period. To indicate the position of the company it is preferable to compare the value with main competitors.

Resolving the problems with the operating cycle exceeding the normative range:

The decline of the operating cycle can be reached through the production process optimization or the increase of the accounts receivable management efficiency. Declining the average period of the accounts receivable collection will allow to increase the efficiency of the operating process.

Formula(s):

Operating Cycle = Accounts Receivable Turnover in Days + Inventory Turnover in Days

Operating Cycle = (Average Gross Receivables ÷ (Net Sales ÷ 360)) + (Average Inventory ÷ (Cost of Goods Sold ÷ 360))

Should be remembered that the inventories turnover happens to be underestimated during the calculation. If the company uses the classic business year (with the end on December, 31), and the indicator is being calculated with use of the values at the beginning and the end of the year, calculated values for the inventory turnover might not reflect the real state of things. That's why it is preferable to use monthly or daily data.

Average Inventories (the preferable calculation method) = Sum of the inventory amounts at the end of each working day ÷ Number of working days

Average Inventories (if only monthly data available) = Sum of the inventory amounts at the end of each month ÷ Number of months

Average Inventories (if only annual data available) = (Inventory amount at the beginning of the year + Inventory amount at the end of the year) ÷ 2

Same should be the calculation method selection for the accounts receivable turnover calculation:

Average Accounts Receivable (the preferable calculation method) = Sum of the accounts receivable amounts at the end of each working day ÷ Number of working days

Average Accounts Receivable (if only monthly data available) = Sum of the accounts receivable amounts at the end of each month ÷ Number of months

Average Accounts Receivable (if only annual data available) = (Accounts receivable amount at the beginning of the year + Accounts receivable amount at the end of the year) ÷ 2

Example:

 Company A Balance Sheet \$ as of 12/31/YEAR1 \$ as of 12/31/YEAR2 \$ as of 12/31/YEAR1 Assets II. CURRENT ASSETS Inventories 221 407 449 Accounts Receivable 204 328 322 TOTAL 1940 1841 1849 Balance 3048 2947 2841

 Company A Income Statement \$ YEAR2 \$ YEAR3 Net Sales 3351 3854 Cost of goods sold 3067 3207

Operating Cycle (Year 2) = ((328 + 204) ÷ 2 / (3351 ÷ 360)) + ((221 + 407) ÷ 2 / (3067 ÷ 360)) = 65,4

Operating Cycle (Year 3) = ((328 + 322) ÷ 2 / (3854 ÷ 360)) + ((407 + 449) ÷ 2 / (3207 ÷ 360)) = 78,4

In year 1 the operating cycle of a company was 65,4 days, after what it increased to 78,4 days in year 2. This means the company needed 65,4 days in year 1 between acquiring goods and realizing the cash from sales. In year 2 it needed 78,4 days to complete this process.

Conclusion:

The company is interested in declining its operating cycle since this leads to the faster obtaining of funds from sales of goods and services. This can be done through improving either the production workflow or the accounts receivable collection process. The duration of the operating cycle can be influenced by the payment terms that the company has agreed with its suppliers, the policy of fulfillment orders, credit policy, etc.