Operating Cycle Formula

What is Operating Cycle Formula?

The formula for the operating cycle basically 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. In other words, the operating cycleThe Operating CycleThe operating cycle of a company, also known as the cash cycle, is an activity ratio that measures the average time required to convert the company's inventories into cash.read more determines the time taken by a business to purchase inventory, then sell the inventory and then collect the cash from the sale of the inventory. The cycle plays a significant role in assessing the efficiency of a business.

Mathematically, it is represented as,

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

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Source: Operating Cycle Formula (wallstreetmojo.com)

 
  • The first part is pertaining to 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 pertaining to the credit sales, and it asses in how much of the amount of time the company is able to collect the cash from their sales, and it is represented by the account receivable period.

Explanation

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 Average InventoryAverage Inventory is the mean of opening and closing inventory of a particular period. It helps the management to understand the inventory that a business needs to hold during its daily course of business.read more during the year, which can be calculated as the average of opening inventory and closing inventory from the balance sheet. Then, the COGSCOGSThe cost of goods sold (COGS) is the cumulative total of direct costs incurred for the goods or services sold, including direct expenses like raw material, direct labour cost and other direct costs. However, it excludes all the indirect expenses incurred by the company.read more can be computed from the income statement. Now, the inventory period can be calculated by dividing the average inventory by COGS and multiplied by 365 days.


    Inventory Period = Average Inventory / COGS * 365

  2. Next, determine the average accounts receivableAccounts ReceivableAccounts receivables refer to the amount due on the customers for the credit sales of the products or services made by the company to them. It appears as a current asset in the corporate balance sheet.read moreAccounts receivables refer to the amount due on the customers for the credit sales of the products or services made by the company to them. It appears as a current asset in the corporate balance sheet.read moreAccounts receivables refer to the amount due on the customers for the credit sales of the products or services made by the company to them. It appears as a current asset in the corporate balance sheet.read more during the year, which can be calculated as the average of opening accounts receivable and closing accounts receivable from the balance sheet. Then, the net credit salesNet Credit SalesNet credit sales is the revenue generated from goods or services sold on credit excluding the sales discount, sales allowance and sales return. It even amounts to the accounts receivables for a certain accounting period.read moreNet credit sales is the revenue generated from goods or services sold on credit excluding the sales discount, sales allowance and sales return. It even amounts to the accounts receivables for a certain accounting period.read moreNet credit sales is the revenue generated from goods or services sold on credit excluding the sales discount, sales allowance and sales return. It even amounts to the accounts receivables for a certain accounting period.read more can be taken from the income statement. Now, the accounts receivable period can be calculated by dividing average accounts receivable by net credit sales and multiplied by 365 days.


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

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

Calculation Examples of Operating Cycle

Let’s see some simple to advanced examples to understand it 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 reportThe Annual ReportAn annual report is a document that a corporation publishes for its internal and external stakeholders to describe the company's performance, financial information, and disclosures related to its operations. Over time, these reports have become legal and regulatory requirements.read more 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 above-given data we will calculate Inventory Period (days) of company XYZ

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 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 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 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 have an understanding of 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, then it means that the company takes a longer 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 be used to compare companies in the same industry or conduct trend analysis to assess its 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 that whether its operations are on the path of improvement or not.

Recommended Articles

Guide to Operating Cycle Formula. Here we discuss how to calculate Operating Cycle using practical examples along with downloadable excel templates. You may learn more about Financial Analysis from the following articles –

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