What Is an Operating Cycle? Plus How To Calculate It
By Indeed Editorial Team
Updated August 5, 2022 | Published February 4, 2020
Updated August 5, 2022
Published February 4, 2020
Illustration of three types of businesses in a row.
Tracking an operating cycle through the years is a great way to gauge how your business is doing financially. It can also help determine its efficiency and how smoothly operations are running. Though a company's operating cycle depends on the industry, knowing its operating cycle is useful when comparing itself to competitors. Additionally, a business’s operating cycle might ultimately determine whether or not investors take an interest in the company.
In this article, we discuss what an operating cycle (OC) is and why it's important for a business to track and know, how to calculate an operating cycle and ways to shorten it.
What is an operating cycle?
An operating cycle refers to the time it takes a company to buy goods, sell them and receive cash from the sale of said goods. In other words, it's how long it takes a company to turn its inventories into cash.
The length of an operating cycle is dependent upon the industry. Understanding a company's operating cycle can help determine its financial health by giving it an idea of whether or not it'll be able to pay off any liabilities.
For example, if a business has a short operating cycle, this means it'll be receiving payment at a steady rate. The faster the company generates cash, the more it'll be able to pay off any outstanding debts or expand its business accordingly.
The flow of a cash operating cycle is as follows:
Obtaining raw material
Having finished goods
Having receivables from making a sale
Obtaining cash (receiving payment from customers)
It's also important to differentiate an operating cycle from a cash cycle. Whereas they're both helpful and provide invaluable insight, a cash cycle lets companies see how they're able to manage cash flow, whereas an operating cycle determines the efficiency of the operation.
Why is the operating cycle important?
The operating cycle is important because it can tell a business owner how quickly the company is able to sell inventory. Simply put, it determines the company's efficiency.
A shorter operating cycle is more favorable as it means the company has enough cash to maintain operations, recover investments and meet various obligations. In contrast, if a business has a longer operating cycle, it means the company requires more cash to maintain operations.
Just as there are many influences on a company's operating cycle, there are also many ways that an operating cycle can help determine a company's financial standing. The better a business owner understands the company's operating cycle, the better that owner will be able to make decisions for the benefit of the business.
How to determine an operating cycle
In order to determine a company's efficiency, business owners need to calculate their operating cycle. Follow these steps to make this calculation:
1. Determine the inventory period
A business owner first needs its company's inventory period when calculating its operating cycle. An inventory period refers to how long a company holds its inventory before it's sold. The inventory period can be calculated as follows:
Inventory period = 365 / inventory turnover
To determine a company's inventory turnover, divide the cost of goods sold by the average inventory. The average inventory refers to the average of a company's opening and closing inventory. This can be found on the company's balance sheet, whereas the cost of goods sold can be found on the company's income statement.
2. Determine the company's accounts receivable
Business owners also need to know their accounts receivable in their operating cycle calculation. Accounts receivable refers to the amount of money a customer owes a company. Accounts receivable can be calculated as follows:
Accounts receivable period = 365 / receivables turnover
To determine a company's receivables turnover, divide credit sales by the average accounts receivable.
3. Calculate the operating cycle
The following formula can be used for calculating the operating cycle:
Operating cycle = inventory period + accounts receivable period
This equation can also be used:
Operating cycle = (365 / (cost of goods sold / average inventory)) + (365 / (credit sales / average accounts receivable))
The resulting number is the number of days in the company's operating cycle.
Tips for shortening a company's operating cycle
Here are several tips to consider when attempting to shorten a company's operating cycle:
Implement a stricter credit policy: Customers are more apt to pay for their purchases on time if companies have a stricter credit policy.
Reduce the time period on payment terms: The quicker a company is able to collect accounts receivables, the shorter their operating cycle is likely to be.
Quickly sell a company's inventory: The quicker a company sells its inventory, the shorter its operating cycle should be.
Examples of operating cycles
To understand operating cycles, it's important to consider various scenarios. Here are some examples of operating cycles:
Let's say Cindy owns a clothing store. Her company's operating cycle would begin when she started paying for the materials to make various garments. The operating cycle wouldn't end in this case until all clothing items are produced, sold and the cash has been received from various customers.
Let's say Bob owns a bakery and he's trying to determine how well operations are running at his shop. To do this, he'll need to calculate his company's operating cycle. This means the cycle would start when he began paying for the goods, materials and ingredients used to make various pastries and baked goods. His bakery's operating cycle wouldn't end until all of his baked goods have been sold to customers and he's received cash from his sales.
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