What Is an Operating Cycle and How Is It Calculated?

The operating cycle talks about the time it takes for a business to turn its inventory over, or the time it takes to receive payment for goods and services sold. All of the assets in your business are turned into products/services/cash which is then turned back again. 

It is used to calculate accounts receivable turnover, inventory turnover, average collection period (accounts receivable days), and average payment period (inventory days). 

The length of a company’s operating cycle can impact everything from their ability to finance new growth initiatives to the interest rates they’re offered on loans.

Why The Operating Cycle Is Important

There are a few key reasons why the operating cycle is so important.

First, the length of the operating cycle can impact a company’s cash flow. The longer the cycle, the more time a company has to pay its bills and the less time it has to generate revenue. This can put a strain on a company’s finances and make it difficult to invest in new initiatives or expand their business.

Second, the operating cycle can have a big impact on a company’s profitability. The longer the cycle, the more time a company has to sell its products at a lower price in order to make back the money they’ve already spent. This decreases the profits and affect a company’s ability to invest in new growth initiatives.

Finally, the operating cycle can also impact a company’s relationships with its creditors. The longer the cycle, the higher the chance that a company will default on its debt payments. This can lead to higher interest rates and fees, and could ultimately damage a company’s credit rating.

How Does It Relate to a Company’s Financial Health

The operating cycle is important for measuring the financial health of a company.

It can be used to tell how efficient management’s use of assets are, which in turn affects capital intensity (the degree or proportion that fixed costs represent in total costs), fixed overhead turnover (the number of times fixed overheads are utilized during an accounting period) and return on investment (ROI).

It also shows how long it takes a company to use its cash. In this sense, the operating cycle provides information about a company’s liquidity and solvency.

Considered from a larger perspective, the operating cycle affects the financial health of a company by giving them an idea of how much its operations will cost, as well as how quickly it can pay its debts.

How To Calculate Operating Cycle

The Operating Cycle is calculated by getting the sum of the inventory period and accounts receivable period.

Operating Cycle = Inventory Period + Accounts Receivable Period

Where:

Inventory Period is equal to the number of days it takes to sell inventory. This is calculated by dividing 365 with the quotient of cost of goods sold and average inventory or inventory turnover.

Inventory Period = 365 / (Cost of Goods Sold / Average Inventory)

Accounts Receivable Period is equal to the number of days it takes to receive payment for goods and services sold. This is computed by dividing 365 with the quotient of credit sales and average accounts receivable or receivable return.

Thus, the detailed calculation of the Operating Cycle is:

Operating Cycle = 365 / (Cost of Goods Sold / Average Inventory) + 365 / (Credits Sales / Average Accounts Receivable)

Ways To Improve Your Company’s Operating Cycle

To improve an operational process, business owners should look at the accounts receivable turnover, average payment period (inventory days), and inventory turnover.

The operating cycle can also be improved by reducing the number of times customers must pay for a product before purchasing another one, as well as reducing the number of days between when a company buys its raw materials and then sells its finished product to customers.

Other ways to improve the operating cycle includes:

  • Managing cash and credit better
  • Ensuring that accounts receivable, inventory and payable balances are always accurate and up to date
  • Making timely payments for goods and services

By optimizing the operation cycle, a company can greatly improve its cash management and decrease costs.

Why The Operating Cycle is Important to Other Aspects Of A Business Like Marketing And Finance

An efficient operational process can also help reduce other costs like marketing, finance, etc.

For example, the net accounts receivable turnover is used to determine how often customers must pay for their product before they can make another purchase. This, in turn, helps you determine how much time and resources need to be allocated to collecting bad debt.

Operational efficiency also affects finance because it affects things like cash flow and inventory levels.

For example, an efficient collection period (accounts receivable days) could reduce the number of outstanding invoices, which makes it easier for a business owner to accurately forecast cash receipts and expenses for each accounting period.

Also, high inventory turnover can reflect a company’s efficient operations, which in turn lead to increased shareholder value.

The Importance of an Efficient and Effective Operational Process in Business Operations

An effective operational process helps businesses by improving their cash flow, which in turn has a positive effect on other aspects of their business.

For example, an efficient sales force can increase the company’s market share and reduce the time it takes to acquire new customers.

Similarly, an efficient production process can help improve product quality and turnover speed while reducing manufacturing errors.

Operational efficiency is also important because it reduces costs associated with things like inventory, accounts receivable, non-selling expenses (i.e., general administrative), payroll overhead, etc. What this means is that more money is left for shareholder value or reinvestment into the business.

Examples of Companies With High Or Low Operational Efficiency

The companies with high operational efficiency are typically those that provide goods or services with short shelf lives i.e., clothing, electronics, etc.

They also make large quantities of these items and have little to no inventory to maintain. For example, take a look at retailers like Wal-Mart and Costco, which can turn their entire inventory over nearly five times during the year.

On the other hand, companies that sell products or services that do not have shorter life spans or require less inventory tend to be less efficient in terms of operational processes.

For example, businesses like airlines operate on longer cycles due to their reliance on expensive aircraft and employees who often work around the clock.

The Bottom Line

Capitalizing on your operational efficiency can have positive effects that are felt throughout the rest of your business. What this means is that investing in operational process improvement can help reduce costs, increase speed, and improve quality, which will likely lead to increased profits at the end of the day.

Operational efficiency is also important because it reduces costs associated with things like inventory, accounts receivable, non-selling expenses (i.e., general administrative), payroll overhead, etc. What this means is that more money is left for shareholder value or reinvestment into the business.

An effective operational process helps businesses by improving their cash flow, which in turn has a positive effect on other aspects of their business.

The companies with high operational efficiency are typically those that provide goods or services with short shelf lives i.e., clothing, electronics, etc. They also make large quantities of these items and have little to no inventory to maintain.

On the other hand, companies that sell products or services that do not have shorter life spans or require less inventory tend to be less efficient in terms of operational processes.

Operating Cycle FAQs

An operating cycle refers to the number of days it takes for a company to convert its investment in inventory, accounts receivable (A/R), and accounts payable (A/P) into cash.
The higher the operating cycle, the lower the liquidity will be because more time elapses before cash is obtained.
Retailers and other businesses that sell products with low shelf lives (i.e., groceries, clothing, electronics) operate on shorter cycles while services that require employees or equipment to be utilized for a longer duration come with higher operational costs and thus have longer operating cycles.
An effective operational process helps businesses by improving their cash flow, which in turn has a positive effect on other aspects of their business. Reducing costs while also increasing speed and improving quality can be beneficial to business owners. Increased profits are often the end result of running a business more efficiently.
One example would be to decrease the amount of inventory your company holds. This means that companies can reduce or eliminate slow-moving or obsolete inventory, which in turn reduces the cost and time needed to dispose of these items.

True Tamplin, BSc, CEPF®

About the Author
True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website, view his author profile on Amazon, or check out his speaker profile on the CFA Institute website.