An operating cycle begins when a company spends money to purchase items for inventory and ends when the company receives money from customers who buy those same items. The operating cycle is also referred to as the cash-conversion cycle, since it's the length of time between paying cash and receiving cash. It's typically measured in days, and the shorter it is, the better. Tracking the progress of an item through a company shows how to calculate an operating cycle.
How the Cycle Works
It helps to imagine the operating cycle as a clock that starts running when the company receives an item for inventory. It keeps running as long as the item is in inventory. If the item is sold for cash, the clock stops. However, if the item is sold on credit, the clock runs until the company actually receives payment. One additional consideration: Companies typically order inventory on credit, paying for it only after receiving it. That reduces the length of the cycle.
Formula for the Cycle
A company's operating cycle is made up of three elements: the average time items remain in inventory, called "days inventory outstanding" or DIO; the average time it takes customers to pay their bills, called "days sales outstanding" or DSO; and the average time it takes the company to pay its own bills, called "days payables outstanding" or DPO. The formula: Operating Cycle (in days) = DIO + DSO - DPO
Elements of the Formula
To calculate DIO, take the average value of the company's inventory over the course of a year, divide by the total amount of inventory purchases that year, then multiply by 365. To calculate DSO, take the average accounts receivable balance, divide by the total amount of sales on credit, then multiply by 365. To calculate DPO, take the total amount of inventory purchased on credit, and divide by the average accounts payable balance. This gives you payables turnover. Divide 365 by payables turnover to get DPO.