Operating cycle

The Operating cycle is the period required for a business to acquire or produce goods or services, sell them, and collect the resulting cash from customers.

A simplified representation is:

$Operating Cycle = Inventory Conversion Period + Receivables Collection Period$

where:

$Inventory Conversion Period$ = time required to acquire or produce inventory and convert it into sales;
$Receivables Collection Period$ = time required to collect cash from customers after a sale made on credit.

Operating cycle calculation

The operating cycle can be expressed using average inventory and accounts receivable:

$Operating Cycle = Days Inventory Outstanding + Days Sales Outstanding$

The Days inventory outstanding (DIO) can be approximated as:

$DIO = \frac{Average Inventory}{Cost of Goods Sold} \times 365$

The Days sales outstanding (DSO) can be approximated as:

$DSO = \frac{Average Accounts Receivable}{Net Credit Sales} \times 365$

Therefore:

$Operating Cycle = (\frac{Average Inventory}{Cost of Goods Sold} \times 365) + (\frac{Average Accounts Receivable}{Net Credit Sales} \times 365)$

The number of days used in the calculation may vary depending on the analytical convention and reporting period.

Example

Suppose a company has:

average inventory of $20 million;
cost of goods sold of $100 million;
average accounts receivable of $15 million;
net credit sales of $120 million.

The inventory conversion period is approximately:

$DIO = \frac{20}{100} \times 365 = 73 days$

The receivables collection period is approximately:

$DSO = \frac{15}{120} \times 365 \approx 45.6 days$

The operating cycle is therefore approximately:

$Operating Cycle = 73 + 45.6 = 118.6 days$

The company takes approximately 119 days, on average, to convert inventory purchases into cash collected from customers.

Operating cycle and cash conversion cycle

The operating cycle differs from the Cash conversion cycle (CCC) because the cash conversion cycle also considers the period for which the company receives financing from suppliers through accounts payable.

The operating cycle is:

$Operating Cycle = DIO + DSO$

The cash conversion cycle is:

$Cash Conversion Cycle = DIO + DSO - DPO$

where $DPO$ is Days payable outstanding, representing the average time taken to pay suppliers.

Thus:

$Cash Conversion Cycle = Operating Cycle - DPO$

Operating cycle and working capital

The operating cycle is closely related to Working capital management.

A simplified sequence is:

$Cash \to Inventory \to Sales \to Accounts Receivable \to Cash$

The length of this cycle affects the amount of working capital a business may need to support its operations.

A longer operating cycle can increase the amount of capital tied up in inventory and receivables.

A simplified relationship is:

Failed to parse (syntax error): {\displaystyle \text{Longer Operating Cycle} \rightarrow \text{More Capital Tied Up in Operations} \end{math> ==Operating cycle and current liabilities== The operating cycle is also relevant to the classification of certain assets and liabilities as current. Under applicable accounting frameworks, the operating cycle can be relevant when determining whether an asset or liability is classified as current, particularly for entities whose normal operating cycle extends beyond 12 months. A simplified relationship is: <math> \text{Operating Cycle} \rightarrow \text{Timing of Operating Asset and Liability Conversion} \end{math> The precise classification criteria depend on the applicable accounting standards. ==Operating cycle by industry== The length of an operating cycle can vary significantly between industries. For example: * a supermarket may have a relatively short inventory cycle; * a manufacturer may require substantially more time to produce and sell goods; * a construction business may have a much longer operating cycle; * a service business may have little or no inventory conversion period. Consequently, operating-cycle comparisons are generally more meaningful between companies with similar business models. ==Operating cycle and liquidity== The operating cycle can affect [[Liquidity risk]] because businesses generally need sufficient financial resources to fund operations until sales are converted into cash. A simplified relationship is: <math> \text{Longer Operating Cycle} \rightarrow \text{Longer Cash-Flow Delay} \rightarrow \text{Greater Working Capital Requirement} }

However, the actual liquidity impact also depends on supplier payment terms, customer payment behavior, financing arrangements, and the stability of operating cash flows.

Operating cycle

Contents

Operating cycle calculation

Example

Operating cycle and cash conversion cycle

Operating cycle and working capital

See also