What is Operating Cycle & How to calculate it? (With Formula)

Introduction

If you’re new to the world of finance or business, the concept of an operating cycle might seem a bit puzzling. You might have noticed that businesses talk about their operating cycle differently, depending on their industry or size, adding to the confusion. 

So, to clear up any confusion you might have, let’s break down the operating cycle in simple terms, from what it is to how to calculate it to the operating cycle formula and more.

What Is an Operating Cycle?

The operating cycle is a financial metric that measures the time it takes for a company to convert its investments in inventory and accounts receivable into cash. Essentially, it is the duration between the acquisition of inventory and the collection of cash from customers after selling the inventory.

It is crucial for businesses to calculate their operating cycle as it helps them stay informed about how efficiently they are managing their resources and operations.

Typically, a shorter operating cycle means a company converts inventory and receivables into cash more quickly. As a result, your business has enhanced liquidity, can meet its short-term obligations, and can invest in growth opportunities.

On the other hand, a longer business operating cycle can strain cash flow, as money is tied up in inventory and receivables for an extended period. This can lead to cash shortages, making it challenging to pay bills, cover operating expenses, or seize new opportunities.

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Importance of Operating Cycle

Knowing the length of their operating cycle allows businesses to better manage cash flow by anticipating when cash will be tied up in inventory and receivables and when it will be available from sales. Besides, here’s why measuring the operating cycle is significant for businesses:

• Helps in cash flow management: The operating cycle helps manage cash flow by revealing how quickly inventory and receivables convert into cash, ensuring liquidity.
• Aids in financial planning: It enables business leaders to perform accurate financial planning by forecasting cash needs and optimizing resource allocation for better budgeting and investment.
• Improves operational efficiency: Identifies inefficiencies in inventory management and receivables collection, enabling businesses to streamline operations and reduce costs.
• Supports strategic decision-making: Understanding the operating cycle allows businesses to make more strategic decisions regarding inventory purchases, credit terms, and pricing strategies. 

Factors Impacting the Operating Cycle 

Knowing what factors impact the operating cycle can help businesses improve process efficiency and maintain higher liquidity. Let’s take a look at these factors:

• Goods purchasing or manufacturing process

  Whether you’re purchasing goods or manufacturing them, how efficiently your business does it directly impacts the length of the business operating cycle. This is because efficient purchasing with suppliers reduces inventory costs and stockouts while effective manufacturing speeds up production and delivery. Both processes affect the time taken to convert raw materials into cash, thus shortening or lengthening the operating cycle.

• Inventory holding period

  The inventory holding period, the time goods remain in stock before sale, affects the operating cycle by influencing cash flow and storage costs. A longer holding period ties up cash in unsold inventory, extending the cycle, while a shorter period improves liquidity and reduces holding costs, accelerating the cycle.

• Receivables collections

  How easily a business can collect its receivables also plays an important role. This particularly depends on the credit terms offered to the customer, the credit policy, and the collection strategies implemented by the business to collect the debts. The slower collection extends the cycle and can potentially strain financial resources.

Operating Cycle Formula 

To calculate the operating cycle, determine two key components: the inventory period (time inventory sits before selling) and the receivables period (time to collect payments). The operating cycle is the sum of both these periods. Here’s the formula for the operating cycle:

Here’s a step-by-step breakdown of what each of these component mean and how to calculate them:

• Inventory period

  The inventory period measures the average number of days it takes for a business to sell its entire inventory during a specific period. It is calculated as follows:

  Inventory period = 365/ Inventory turnover

  Where:

  Inventory turnover = Cost of goods sold/ Average inventory

• Receivables period

  Also known as Days Sales Outstanding (DSO) the receivables period measures the average time it takes for a company to collect payment from its customers after a sale. It is calculated as follows: 

  Receivable period = 365/ Receivable turnover

  Where:

  Receivable turnover = Credit sales/ Average accounts receivable

An Example of How to Calculate the Operating Cycle

Let’s take an example to help you understand how to calculate the operating cycle. Suppose a retail company wants to calculate its operating cycle with the following financial data:

Here is the stepwise process to calculate the operating cycle for the company:

Step1: Calculate the inventory turnover

Inventory turnover = 300,000/60,00 = 5

Step 2: Calculate receivable turnover

Receivable turnover = 500,000/40,000 = 12.5

Step 3: Calculate inventory period and receivable period

Inventory period= 365/5 = 73 days

Receivable period= 365/12.5 = 29.2 days

Step 4: Calculate the operating cycle

Operating cycle = 73+29.2 = 102.2 days

This means it takes the company about 102.2 days to convert its inventory into cash through sales and collections.

Cash Cycle Vs. Operating Cycle 

Usually, when talking about operating cycles, another important metric that comes into the picture is the net operating cycle, also known as the cash cycle. At first, it may sound like the same business operating cycle but they both are different. 

The Net operating cycle, also known as the cash conversion cycle, takes into account both the time required to convert assets into cash and the time taken to pay suppliers. It combines the time for inventory turnover and receivables collection minus the payables period.

This can be well understood by the formula as follows:

Cash cycle = Inventory period + Accounts receivable period – Accounts payable period

Where: 

• Inventory period = 365/ Inventory turnover
• Receivable period = 365/ Receivable turnover
• Accounts payable =365/ Payable turnover

Therefore, while the operating cycle focuses solely on the time to turn inventory into cash, the cash cycle provides a fuller picture by factoring in how long the company can delay payments to suppliers. This adjustment gives a clearer view of cash flow efficiency and working capital management, showing the net duration for converting operational investments into cash.

Best Practices for Managing the Operating Cycle

Every business owner would want their operating cycle to be as short as possible to enhance cash flow, improve liquidity, and optimize operational efficiency. Here are some best practices to achieve a shorter operating cycle:

• Manage receivable collection efficiently

  Streamlining the collection process can make a big difference in improving the operating cycle. Ensure your business sends invoices quickly and use automated reminders to follow up on overdue payments. Moreover, collection teams must regularly review outstanding accounts to ensure timely collections and minimize delays.

• Optimize manufacturing or inventory management

  Another thing to take care of in order to improve the operating cycle to focus on streamlining inventory and production processes. Implement efficient inventory practices to reduce excess stock and holding costs. Alongside, businesses must regularly review and adjust their production schedules to minimize delays and improve efficiency.

• Strengthen supplier relationships

  Building strong relationships withs suppliers can help business in reaping multiple benefits, such as negotiating favorable payment terms to extend your payables period, making changes in orders as and when needed, reliable delivery, etc. Maintain open communication, address issues promptly, and collaborate on improving supply chain efficiency. 

• Utilize technological advancements 

  Using automation tools like HighRadius accounts receivable solutions that help businesses streamline their collections operations. These tools enhance efficiency by automating invoicing, collections, and cash application, reducing manual errors and accelerating cash flow. By integrating advanced systems, businesses can optimize their operating cycle, improve accuracy, and gain real-time insights into their financial operations.

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FAQs

1) What are normal operating cycles?

Normal operating cycles are the usual time it takes for a business to turn inventory into cash. The duration of the operating cycle varies by industry. For instance, for the retail industry, it may be short, while for the manufacturing industry, it might be longer due to production times.

2) How long is the typical operating cycle?

The operating cycle length depends on the industry. In retail, it may be 30-60 days because of quick inventory turnover, whereas in manufacturing, it can extend to 90 days or more due to production time. The cycle includes the time to purchase or produce inventory, sell it, and collect payment.

3) Is a low operating cycle good?

Yes, a low operating cycle is generally beneficial for the business. It indicates that a business converts inventory and receivables into cash more quickly, improving liquidity and reducing the need for external financing. However, it should align with industry standards to ensure competitiveness.

4) How to improve the operating cycle?

To improve the operating cycle, streamline inventory management, optimize receivables by offering early payment discounts and automating invoicing, and strengthen supplier relationships to negotiate better payment terms. Regularly monitor and adjust operating cycle best practices as needed.

5) What will increase the operating cycle?

An increased operating cycle can result from slower inventory turnover, longer times to collect payments from customers, or delays in paying suppliers. Issues like production delays, excess stock, or lenient credit terms can all contribute to a longer cycle, affecting cash flow.