What is the operating cycle?

The operating cycle is a great way to measure the company’s efficiency to determine how smoothly operations are running and how a business is doing financially well. This article will give you clear insight into the OC, its importance, and formulas and calculations.

Outline

• Operating cycle 
• Importance of operating cycle
• Factors impacting operating cycle
• Formula and calculation of accounting cycle
• Example of an operating cycle
• Key takeaways

Operating cycle

An operating cycle(OC) refers to the period of time it takes businesses to buy goods, sell out the goods, and receive cash/money from the customers in exchange for the goods. In simple words, it is the estimation of the time takes a company to turn its inventories into cash.

The flow of the operating cycle is as follows:

1. Purchase goods or raw materials
2. Produce goods or services for sale
3. Sell goods or services
4. Collect cash from customers

The similar words to the OC that most people get confused about are the cash-to-cash cycle, net operating cycle, and cash conversion cycle. All these terms come in the context of the operating cycle.

Net operating cycle- The time period between paying for inventory and cash collected from a sale of inventory.

Cash conversion cycle– it measures how long a firm will be deprived of cash if it increases its investment in inventory in order to expand customers’ sales.

Cash-to-cash cycle- The time period between the business paying for the supplies for inventory and receiving cash from its customers. 

                           

Importance of operating cycle

The OC provides insight into the operating efficiency of the company. Thus, it plays a vital role in estimating the cash cycle for maintaining or growing an organization’s operations. 

For example, if a company’s OC is short, then the company can make a turnaround relatively quickly. In contrast, if a business has a longer OC, it means the company requires more cash to maintain operation.

Factors impacting operating cycle

The following are the factors that influence the OC.

1. Time duration of production 

The time period of the operating period will increase if the production process consumes more time to make raw products.

2. Holding period of finished products

The holding period directly affects the OC. If the product is held for a long period in a warehouse or store, the time duration of OC will be increased. on the other hand, if held for a less time period, the OC will be decreased.

3. Credit period allowed by the supplier

In this situation, the OC of the business will be shorter when supplies of the goods allow the business a longer credit period. In contrast, the increase in the time duration will allow the business to hold some cash or goods in advance.

4. Credit period allowed to customers

The time duration of OC will increase if the business allows its customer a long credit period. Whereas, the time duration of OC will be decreased if businesses allow less credit period.

Formula and calculation of accounting cycle

There OC can be calculated through two different formulas are as follows:

1. Operating Cycle = Inventory period +Account receivable period 

Inventory period- It is the duration of the time period in which inventory is held in the warehouse until sold 

Account receivable period-the time takes to collect cash from customers for the sale of goods/services. 

Calculation of Operating cycle:

Example # 1

Let us consider an example to compute the OC for a company  Jhon Traders ltd. Suppose a financial year ended on May 20, 2022, and the following information will be available.

The below table shows the data for the calculation of the OC of the company Jhon Traders Ltd for the financial year ended on May 20, 2022

                                         

Hence, with the above data, we will calculate the company John Traders inventory period (days)

Where,

Now let us calculate both parts of the OC:

  We will find the average inventory through the below formula

   $6,000 + $3000 / 2

Average inventory                    $4,500

We will find average receivable through below formula

$5,000+$4,000/2

Average receivable                       $4,500

Now let us put value in OC formula

                  $4,500 x 365 / $60,000+ $4500 x 365/ $15,000

$1,642,500 +     $1,642,500

    $ 60,000          $15,000\

    27.3        +      109.5

= 137  (days)                                     

Key Takeaways

• Thus, the OC is the estimation of the time takes a company to turn its inventories into cash.
• The similar words of OC are the cash-to-cash cycle, the net operating cycle. and the cash conversion cycle
• Moreover, it provides insight into the operating efficiency of the company