Business Operating Cycle
When a business trades, it purchases goods, holds them as inventory, converts them to a product for sale and sells them on credit, and finally it collects the cash from the sale. The operating cycle in financial management describes the time it takes to complete this process in days.
The operating cycle definition is the time period it takes from inventory purchase until the receipt of cash from the sale of the inventory.
Operating Cycle Formula
Inventory Conversion Period
The inventory conversion period is the length of time from the purchase of inventory to the time the sales are made on credit.
It is important to realize that in this formula inventory is the average of the beginning and ending inventory.
Accounts Receivable Collection Period
The accounts receivable collection period is the average number of days it takes to collect accounts receivable. This is sometimes referred to the days sales outstanding or DSO.
Again in this formula accounts receivable is the average of the beginning and ending accounts receivable balances
Operating Cycle Example
Suppose a business has the following information about sales, cost of sales, inventory and accounts receivable. The information can be used to calculate the operating cycle of the business.
| Account | Amount |
|---|---|
| Annual sales | 3,000 |
| Annual cost of sales | 1,260 |
| Average inventory | 230 |
| Average accounts receivable | 360 |
In this case the calculation of the cycle is as follows.
Inventory conversion period = Inventory / (Cost of sales / 365) Inventory conversion period = 230 / (1,260 / 365) = 67 days Accounts receivable collection period = Accounts receivable / (Sales / 365) Accounts receivable collection period = 360 / (3000 / 365) = 44 days Operating cycle = 67 + 44 = 111 days
On average it takes 111 days from the purchase of the inventory until the collection of cash.
As can be seen the longer the inventory period and the accounts receivable collection period the longer the operating cycle of the business.
A long cycle means cash is tied up in inventory and accounts receivable. A business should aim to have as short a cycle as possible by reducing inventory holding time (but not so far that inventory shortages appear), and by improving accounts receivable collections.
The operating cycle (OC) differs from the cash conversion cycle (CCC) in that the OC does not allow for the accounts payable payment period. The OC measures the time difference between the purchase of inventory and the collection of cash unlike the CCC which measures the time difference between the payment for inventory and the collection of cash.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.