Operating Cycle

The operating cycle talks about how long it takes a business to convert cash into inventory. 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).

Why the Operating Cycle Is Important

The operating cycle shows how long a business must wait before its cash from sales can be converted back into cash.

It is also critical for managing working capital as it can be used as a benchmark to determine how long it takes for a company to convert its cash into inventory, and then sell that inventory back into cash.

When looking at the operating cycle, business owners should look at the accounts receivable turnover and average collection period (accounts receivable days) and compare them with the inventory turnover and average payment period (inventory days).

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 taking the average daily balance of accounts receivable and inventory and multiplying those balances by their respective turnover ratios.

In other words, the operating cycle is the difference between a company’s debtors and creditors and the time that elapses from the point of sale until payment is received from a customer or expenses are paid.

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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.

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.

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®), 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, his interview on CBS, or check out his speaker profile on the CFA Institute website.

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