The operating cycle is simply defined as the average time that passes between the business’ initial purchase of inventory and the collection of cash proceeds from the sale of inventory. Understanding the length of the operating cycle is essential because it affects the amount of cash the business has on hand to meet short-term obligations. This information is useful to business managers and other company decision-makers as well as potential investors who may consider the length of the operating cycle when determining whether to invest in a particular company.
An analysis of a business’ operating cycle should include a variety of factors, including accounts payable and receivable cycles as well as the inventory cycle. According to a 2006 Entrepreneur article titled, “Working Capital Analysis,” each of these elements are analyzed according to the average number of days it takes to complete each cycle. For example, an accounts receivable analysis would determine the average number of days it takes the business to collect on an account.
The operating cycle of a business is determined by adding the average number of accounts receivable days, or the collection period, to the average number of inventory days, which is also referred to as the age of inventory. The collection period is determined by calculating the amount of time receivables take to return cash. This can be accomplished by dividing the amount of sales for the year by the average accounts receivable balance. Age of inventory is determined by first calculating inventory turnover. Inventory turnover is equal to the cost of goods sold divided by the average inventory. Finally, the age of inventory is obtained by dividing 365 days by inventory turnover.
Operating Cycle Ratio
The operating cycle ratio indicates how much and how long cash is tied up in inventory and receivables. Company decision-makers use the operating cycle ratio to determine what changes should be made to the operating cycle in order to improve efficiency and free up cash that may be needed to meet the company’s short-term obligations. The operating cycle ratio is calculated using the following equation: Operating cycle = age of inventory + collection period.
It is essential that organizational leaders understand how the operating cycle affects their ability to manage all assets. For example, business managers and investors often rely on the operating cycle ratio to determine how efficient the business is at managing its assets in relation to others in the industry. The organization may also use an analysis of the operating cycle to ensure the company has the necessary working capital to meet operational requirements.
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