Raw material >>> Work-in-Process >>> Finished Goods >>> Accounts Receivable >>> Cash
This cycle of raw material conversion to cash is called operating or working capital cycle. In terms of time, it is the time taken after the purchases of raw material till its translation into cash. The total of inventory holding period and a receivable collection period of a firm is the operating cycle time of that firm.
Operating cycle and cash operating cycle are used interchangeably but it’s a misconception. They are different by a small margin but that makes a big difference.
Cash Operating Cycle
Like working capital, operating cycle can also be gross operating cycle (operating cycle) and net operating cycle (cash operating cycle). Cash operating cycle is gross operating cycle less creditor’s collection period. It is the time period for which the working capital is required.
How to Calculate using Formula?
The time of operating cycle can be broken as follows:
1. Inventory Holding Period
• Raw Material Holding Period
• Work-in-process Period
• Finished Goods Holding Period
2. Receivables Collection Period
Formula for Operating Cycle
Operating Cycle = Inventory Holding Period + Receivable Collection Period
Or, Operating Cycle = Raw Material Holding Period + Work-in-process Period + Finished Goods Holding Period + Receivable Collection Period
Formula for Cash Operating Cycle
Cash Operating Cycle = Inventory Holding Period + Receivable Collection Period – Creditor’s Payment Period
Or, Cash Operating Cycle = Raw Material Holding Period + Work-in-process Period
+ Finished Goods Holding Period + Receivable Collection Period – Creditor’s Payment Period
Operating Cycle Example
Suppose $500 Dollar worth of inventory is purchased from a supplier on 20 days credit and it was sold after 40 days of purchasing it. The credit of 40 days is given to the buyer. The buyer paid on completion of the credit period.
The Operating Cycle = Inventory Holding Period + Receivable Collection Period
= 40 + 40
= 80 Days.
Cash Operating Cycle = 80 Days – 20 Days (Supplier’s Credit)
= 60 Days.
Analysis of Operating and Cash Cycle
Operating cycle is extremely important because business is all about the running the operating cycle smoothly. If it is running smoothly, almost everything will be smooth. If any part of the operating cycle is stuck, the whole business gets disturbed. For a manager to effectively manage the business, he should have a deep understanding of his business cycle and potential threats and risks to it. Proactively, he should have ways and means to mitigate those threats and risks.
In our example, operating cycle is 80 days. The entrepreneur should always focus to reduce it as more as possible and that will ensure better utilization of their fixed assets. In turn, they will gain the higher return on their investment.
On the other hand, cash operating cycle is the base for working capital estimations. In our example, working capital requirement is $500 for 60 days. Banks take this as a base for funding their client. A manager handling finance should focus on reducing the cash cycle as that will save him the interest cost. Reducing this cycle means reducing the inventory holding period and increasing the supplier’s payment period. Other than normal strategies, Japanese techniques ‘Just-in-Time (JIT)’ can reduce the inventory holding time practically zero. Bigger companies are trying to adopt JIT with the help of tools like supplier system integration etc.