What is an operating cycle? Why is it important to compute?
A working capital cycle is commonly known as an operating cycle. Any business concern, whether it is a financial concern, a trade organization, or a manufacturing concern, requires a certain amount of time to reap the rewards of its work. That is, by investing money and producing or performing something for a period of time, you will make a profit. However, you will not be able to recoup that profit in cash immediately after making the initial investment. It takes some time to do so. This time period that it takes to go from investing money in assets to converting it back to cash again is referred to as the operating or working capital cycle. Here, the cycle signifies the length of time for realizing cash from money put into any sort of business operations.
What is an operating cycle?
In simple words, the average time between the acquisition of raw materials and the end cash realization is referred to as the operating cycle.
The chart below shows the working of an operating cycle in case of manufacturing concerns:
Cash is used to buy raw materials and other items, i.e. to build inventories. When such inventories are processed in the factory, they are transformed into finished products. And when such products are sold, it gives rise to accounts receivables. Thereafter, the collection of receivables brings cash back into the company and the process continues in a circle as shown in the picture above. This whole cycle takes some days to complete. Thus, the operating cycle portrays the interval between a company’s expenditures on raw materials, labor, and other expenses and the inflow of cash from the sales of goods. It is the time that elapses between cash outlay and cash realization. It can also be said that the cash utilized in productive activity, after some time, comes back through the stages of an operating cycle.
The length of the working capital cycle may vary from one business entity to another depending on the nature of the business and its activities. It does change according to its activities.
In case of trading concerns, the operating cycle will be Cash → Stock → Debtors → Cash.
In case of financial concerns, the operating cycle will be Cash → Debtors → Cash only.
How to calculate the operating cycle?
In a manufacturing concern, the operating cycle is the average time that raw materials remain in stock, less the duration of credit obtained from suppliers, plus the time it takes to produce the goods, plus the time the goods remain in finished inventory, plus the time taken by customers to pay for them.
In the form of an equation, the operating cycle process can be expressed as:
Net Operating Cycle (also known as cash conversion cycle) = R + W + F + D – C
R = Raw material storage period, i.e., the time for which raw materials remain in stock
W = Work-in-progress holding period, i.e., the time taken in the production
F = Finished goods storage period, i.e., the time for which goods remain unsold
D = Receivables (Debtors) collection period, i.e., the time for which cash is due from customers
C = Credit period allowed by suppliers (Creditors), i.e., the time for which credit is availed from the suppliers of raw materials.
All these time periods clubbed together, form the operating cycle of a company. (source)
These components of the working capital cycle are computed as follows:
R = Period of raw material stock (in days) = Average value of Raw stock ÷ Consumption of raw material per day, or
(Average stock of raw material ÷ Purchases) × 365
W = Period of Production = Average value of work in progress ÷ Average cost of production per day, or
(Average value of work in progress ÷ Cost of production) × 365
F = Finished goods storage period = Average Stock of finished goods ÷ Average cost of goods sold per day, or
(Average Stock of finished goods ÷ Cost of goods sold) × 365
D = Period of credit taken by customers = Average receivables ÷ Average value of credit sales per day, or
(Average receivables ÷ Credit sales) × 365
C = Period of credit granted by supplier = Average level of creditors ÷ Purchase of raw material per day, or
(Average creditors ÷ Credit purchases) × 365
Relationship with the estimation of working capital
One of the most dependable ways for calculating working capital is the operating cycle.
The operating cycle creates a need for having working capital or current assets. This is so because, during the length of the operating cycle, cash is tied up in the process of production for a couple of days. It gets realized only when customers pay for the sales of goods produced. Thus, the business needs some cash to keep its activities running during this period, which creates the need for working capital.
Working capital is required to support a given level of activity to pay for the goods and services until cash is received from sales to customers. Efforts should be made that neither there remains any idle cash nor there is a shortage of money to cope with the company’s working process.
The concept of the operating cycle is all the more important for managing working capital when the conversion cycle is longer, because the longer the cycle, the more financial resources the business needs. A company should remain cautious that its operating cycle should not become too long. (source)
If you can get money to move quicker around the operating cycle (e.g., collect amounts due from customers more promptly) or decrease the amount of money tied up (e.g., decrease inventory levels relative to sales), the company will make more cash or it will need to borrow less money to fund working capital. Similarly, if you can negotiate better terms with suppliers (e.g. get longer credit or an increased credit limit); the company will effectively create free finance to help fund future sales.
By determining the relationship between debtors and sales, creditors and sales, and inventory and sales, the operating cycle aids in precisely estimating the needs of working capital. This can be understood well with the help of an example.
Below is a sample example showing the computation of the operating cycle:
|Details of production||Figures in $|
|Raw material inventory consumed during the year||6,00,000|
|The average stock of raw material||50,000|
|Cost of production||5,00,000|
|Average work-in-progress inventory||30,000|
|Cost of goods sold during the year||8,00,000|
|Average finished goods stock held||40,000|
|Average collection period from debtors||45 days|
|Average credit period availed||30 days|
Raw Material storage period (R) = $50,000/ ($6,00,000÷365) = 30 days approx. (30.4167)
Work-in-progress holding period (W) = $30,000/ ($5,00,000÷365) = 22 days
Finished Goods storage period (F) = $40,000/ ($8,00,000÷365) = 18 days
Receivables (Debtors) collection period (D) = 45 days
Credit Period allowed by creditors (C) = 30 days
Net Operating Cycle = 30 + 22 + 18 + 45 – 30 = 85 days
As we see here, the holding period of various constituents of current assets and current liabilities may either contract or expand the net operating cycle. In this example, it takes 85 days for the company to convert its initial outlay of cash for purchases of raw materials back into cash received from sales.
Number of Operating Cycles in a year = 365 days/Operating cycle period = 4.29 times
The operating cycle will repeat itself, on average, 4 times a year.
The amount of working capital required = Total operating cost/Number of operating cycles in a year = $8,00,000/ 4.29 = $1,86,480 approximately.
Here, the working capital requirement is $1,86,480 for 85 days. To this amount, the minimum cash or bank balance that the company wants to maintain will also be added to give the final working capital needed.
Another way to assess the requirement of working capital is to estimate each component of current assets and current liabilities separately and then sum them up. For example, funds to be invested in raw materials inventory may be estimated using this formula:
[Annual production (units) x Material cost per unit]÷365 x Average raw material holding period
Taking the above example, the annual consumption cost of materials is $6,00,000, and materials are held in stock for 30 days.
Therefore, funds needed for raw materials = $6,00,000/365 x 30.4167 = $50,000.
Similar estimations can be made for other components like finished goods, debtors, etc. to arrive at the amount of working capital needed.
The length of the operating cycle represents the performance of management. Shorter the operating cycle, lower would be the requirement of working capital and vice-versa. A shorter cycle is preferred and is indicative of more efficiency in business operations.
|If you collect receivables (debtors) faster||The operating cycle would be smaller|
|If you collect receivables (debtors) slower||The operating cycle would be longer|
|If you get better credit (in terms of duration or amount) from suppliers||The operating cycle would be smaller|
|If you shift inventory (stocks) faster||The operating cycle would be smaller|
|If you move inventory (stocks) slower||The operating cycle would be longer|
Hope the information provided in this blog proves helpful to you!
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