What Is an Operating Cycle and How to Calculate It?
Your company’s operating cycle, together with efficient purchasing software, holds significant importance in projecting the necessary working capital to sustain or expand your business. A shorter operating cycle translates to reduced cash requirements for maintaining your company’s operations. Consequently, your business can experience growth even while operating with narrow profit margins.
But what happens if your operating cycle is unusually long? What factors impact the operating cycle?
Let’s find out.
What Is the Operating Cycle?
Fully understanding the operating cycle is all about getting a clear definition, not one that’s complicated and difficult to understand.
The operating cycle is the number of days it takes for your business to receive inventory, sell the inventory, and collect the cash from the sale of the inventory. Therefore, it’s the time it takes for your company to turn inventory into cash.
If you own a retail business, then the operating cycle doesn’t include any time for production. It’s simply the date from the initial cash outlay to the date of cash receipt from the customer.
Here’s what the process typically looks like:
- Purchase goods or raw materials
- Produce goods or services for sale
- Finished good holding time
- Sell goods or services
- Collect cash from customers
The length of your business’s operating cycle depends on your industry. Other factors that affect the length of your operating cycle include:
- The credit period allowed by the supplier
- The time it takes to convert raw material into a finished product
- The holding period of the finished product
- The credit period allowed to the customer
Importance of the Operating Cycle
The operating cycle is vital to your business operations because it can help you determine the financial health of your company.
That’s because it gives you an idea of whether or not you’ll be able to pay off any liabilities. From there, you’ll be able to estimate the amount of working capital you need in order to maintain or grow your business.
Working capital is the amount of available capital that your company can use for day-to-day operations. A positive amount of working capital means you can meet short-term liabilities and continue day-to-day operations.
But the longer the operating cycle, the more working capital you’ll need.
What’s the Difference Between the Operating Cycle and Cash Conversion Cycle?
The operating cycle represents the time it takes your business to:
- Convert raw material to work in progress
- Then, to finished goods
- Then, to accounts payable
- And finally to cash.
On the other hand, the cash conversion cycle is the amount of time it takes your business to convert resources into cash. Just like the operating cycle, a short cash conversion cycle indicates success.
The operating cycle offers insights into operating efficiencies, while the cash conversion cycle allows you to see how well your company manages cash flow.
Another key difference between the operating cycle and the cash conversion cycle is how they’re calculated.
Calculating the Operating Cycle
The first step to calculating the operating cycle is to determine your inventory period, or how long your company holds inventory before selling it.
Here’s what that formula looks like:
Inventory Period = 365 / Inventory Turnover
Once you determine your inventory period, you can move on to the next formula where you’ll calculate your accounts receivable, or how much money a customer owes your company after using credit to make purchases:
Accounts Receivable Period = 365 / Receivables Turnover
After calculating the inventory period and the accounts receivable period, you can plug those numbers into the operating cycle formula:
Operating Cycle = Inventory Period + Accounts Receivable Period
Calculating the Cash Conversion Cycle
The cash conversion cycle uses elements of the operating cycle formula, but it’s a bit more involved. It involves measuring the time it takes to for inventory to move from one stage to another.
Here’s the formula for the cash conversion cycle:
Cash Conversion Cycle = Days Inventory Outstanding (DIO) + Days Sales Outstanding (DSO) – Days Payables Outstanding (DPO)
Shortening Your Operating Cycle
If your company has a short operating cycle, it means your cash flow is consistent, and you likely won’t have any problems paying current liabilities.
But what if your operating cycle is longer than what it should be? A long operating cycle means your company is taking longer to turn purchases into cash through sales.
And the longer it takes for the operating cycle to be completed, the longer creditors have to wait. As a result, your company may be less likely to obtain credit and continue operations.
You can reduce your operating cycle by speeding up the sale of inventory and reducing the time needed to collect accounts receivable.
One way to do this is through an automated accounts receivable solution. Automating financial data can help you draw insights from data that will yield improvements in real-time and optimize your cash flow process.
