Operating Cycle Formula

Updated on May 13, 2024
Article byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What Is The Operating Cycle Formula?

The Operating Cycle Formula refers to the expression that helps businesses calculate their operating cycle, which is defined as the time a firm takes from getting the inventory onboard to receiving the payment after its sale. Calculating this cycle plays a significant role in assessing the efficiency of a business.

Operating Cycle Formula

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The operating cycle formula in accounting represents a cash flow calculation that intends to determine the time taken by a company to invest in inventory and other similar resource inputs and then return to the company’s cash account.

Key Takeaways

  • . The operating cycle formula shows a cash flow calculation that estimates the time the company invests in inventory and other identical resources put in and then returns to the company’s cash account.
  • Analysts use it to know a company’s operating capability. They use a shorter cycle since it represents the business’s efficiency and success. Also, the company can make up the investment rapidly and has sufficient cash to satisfy the business obligations.
  • It collates similar industries or performs trend analysis to examine the performance across the years. It can help determine whether the company is operating versus other players in the industry.

Operating Cycle Formula Explained

The operating cycle formula in financial management helps determine the time a business takes to purchase inventory, then sell the inventory and then collect the cash from the sale of the inventory. Using the equation to calculate the operating cycle enables the management of a firm be aware of the cash flow in and out of their business.

The business, through this calculation, can check the total time taken from receiving the inventory to storing them, selling them, and customers paying for them. The cash inflow and outflow with respect to the inventory moving in and out becomes easier to observe when the operating cycle is known.

Studying the number of days taken for the inventory to be received, sold, and paid for allows business to check on the debtors creditors, and also the cash they receive or pay for various activities, be it purchase or distribution.

If the operating cycle shows less number of days, it shows the business is on the right track. On the other hand, if the figure obtained is more than what it should be, the businesses are found to be inefficient and lagging behind competitors.

When the operating cycle is shorter, it indicates frequent sale of products, which lets the businesses learn about the extensive demand for the product in the market. On the contrary, if the operating cycle formula reveals longer cycle, it comes as a warning sign for the businesses, indicating lesser movement of inventory in the market, which means the items might not be performing well.

Mathematically, it is represented as,

Operating Cycle Formula = Inventory Period + Accounts Receivable Period

  • The first part is about the current inventory level, and it assesses how quickly the company will be able to sell this inventory. It is represented by the inventory period.
  • Then, the second part is about the credit sales, and it assesses how much time the company can collect the cash from their sales, represented by the account receivable period.

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How To Calculate?

The formula is straightforward as all the required information is easily available in the balance sheet and the income statement, and it can be derived by using the following three steps:

  1. Firstly, determine the average inventory during the year, calculated as the average of opening and closing inventory from the balance sheet. Then, the COGS can be computed from the income statement. Now, the inventory period can be calculated by dividing the average inventory by COGS and multiplying by 365 days.


    Inventory Period = Average Inventory / COGS * 365

  2. Next, determine the average accounts receivable during the year, calculated as the average of opening accounts receivable and closing accounts receivable from the balance sheet. The accounts receivable period can be calculated by dividing average accounts receivable by net credit sales and multiplying by 365 days. Then, the net credit sales can be taken from the income statement.


    Accounts Receivable Period = Average Accounts Receivable / Net credit sales * 365

  3. Finally, it can be calculated by adding the inventory and accounts receivable periods.

Video on Operating Cycle

Examples

Let us see some simple to advanced examples to understand them better:

You can download this Operating Cycle Formula Excel Template here – Operating Cycle Formula Excel Template

Example #1

Let us consider an example to compute the operating cycle for a company named XYZ Ltd. As per the annual report of XYZ Ltd for the financial year ended on March 31, 20XX, the following information is available.

The following table shows the data for calculation of the operating cycle of company XYZ for the financial year ended on March 31, 20XX.

ParticularsAmount
Beginning Inventory$3,000
Ending Inventory$5,000
Beginning Accounts Receivable$6,000
Ending Accounts Receivable$8,000
Credit Sales$140,000
Cost of Goods Sales (COGS)$50,000

So, from the above-given data, we will calculate company XYZ’s Inventory Period (days).

operating cycle formula eg1.1png

Inventory Period = Average Inventory / COGS * 365

= ($3,000 + $5,000) ÷ 2 / $50,000 * 365

= 29.20 days

Now, we will calculate the Account Receivable Period (Days) of company XYZ.

operating cycle formula eg1.2png

Accounts Receivable Period = Average Accounts Receivable / Net credit sales * 365

= ($6,000 + $8,000) ÷ 2 / $140,000 * 365

= 18.25 days

Therefore, the calculation of the Operating cycle of company XYZ will be as follows:

operating cycle formula eg1.3png

Therefore, Operating cycle Formula = Inventory Period + Accounts Receivable Period

= 29.20 days + 18.25 days

OC of company XYZ is as follows:

operating cycle formula eg1.4png

OC of XYZ Ltd is =47 days.

Example #2

Let us take the example of Apple Inc. to calculate the operating cycle for the financial year ended on September 29, 2018.

The following table shows the data for calculation of the operating cycle of Apple Inc for the financial year ended on September 29, 2018.

ParticularsAmount
Beginning Inventory$4,855
Ending Inventory$3,956
Beginning Accounts Receivable$17,874
Ending Accounts Receivable$23,186
Credit Sales$265,595
Cost of Goods Sales (COGS)$163, 756

So, from the above-given data, we will first calculate the Inventory Period (days) of  Apple Inc.

operating cycle formula eg2.1png

Therefore, Inventory Period = Average Inventory / Cost of sales * 365

= ($4,855 Mn + $3,956 Mn) ÷ 2 / $163,756 Mn * 365

= 9.82 days

Now, we will calculate the Account Receivable Period (Days) of Apple Inc.

operating cycle formula eg2.2png

Accounts Receivable Period = Average Accounts Receivable / Net credit sales * 365

= ($17,874 Mn + $23,186 Mn) ÷ 2 / $265,595 Mn * 365

= 28.21 days

Therefore, the calculation is as follows:

operating cycle formula eg2.3png

Operating cycle Formula = Inventory Period + Accounts Receivable Period

= 9.82 days + 28.21 days

OC of Apple Inc is as follows:

operating cycle formula eg2.4png

OC of Apple Inc. is =38 days.

Operating Cycle  Calculator

You can use the following Calculator

Inventory Period
Accounts Receivable Period
Operating Cycle Formula =
 

Operating Cycle Formula = Inventory Period + Accounts Receivable Period
0 + 0 = 0

Relevance and Use

It is essential to understand the concept of the operating cycle formula as it helps to assess how efficiently a company is operating. An analyst can use this cycle to understand a company’s operating efficiency. An analyst would prefer a shorter cycle because it indicates that the business is efficient and successful. Besides, a shorter cycle also indicates that the company will be able to recover its investment fast and has adequate cash to meet its business obligations.

On the other hand, if a company has the longest cycle, it means that it takes a long time to convert its inventory purchases into cash. Such a company can improve its cycle either by implementing measures to quickly sell off its inventory or reduce the time needed to collect receivables.

The operating cycle formula can compare companies in the same industry or conduct trend analysis to assess their performance across the years. A comparison of a company’s cash cycle to its competitors can be helpful to determine if the company is operating normally vis-à-vis other players in the industry. Also, comparing a company’s current operating cycle to its previous year can help conclude whether its operations are on the path of improvement or not.

Frequently Asked Questions (FAQs)

Should the operating cycle be more or less?

A shorter operating cycle is suitable due to the company’s sufficient cash to regulate operations, retrieve investments and fulfill obligations. On the contrary, a longer operating cycle business needs more money to maintain operations.

What are the implications of a negative operating cycle?

A negative operating cycle occurs when a company’s accounts payable (DPO) period is longer than the combined inventory days and days sales outstanding (DSO) periods. This situation is rare and indicates that the company can collect cash from customers before paying suppliers, resulting in a source of cash flow.

What does a longer operating cycle suggest?

A longer operating cycle implies that a company takes more time to convert its inventory and accounts receivable investments into cash. This could be due to slower inventory turnover, delayed customer collections, or extended supplier payment terms. A prolonged operating cycle may impact a company’s liquidity and cash flow management.

Recommended Articles

This has been a guide to what is Operating Cycle Formula. Here, we explain the concept along with how to calculate it, its examples, and relevance and use. You may learn more about Financial Analysis from the following articles –

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