What is the Operating Cycle?
The operating cycle, also known as cash cycle of a company, is an activity ratio measuring the average period of time required for turning the company’s inventories into cash. This process of producing or purchasing inventories, selling finished goods, receiving cash from customers and using that cash to purchase/produce inventories again is a never-ending cycle, as long as the company remains in operation.
As we see from below, the Cash Cycle of Toyota Motors is 96 days, whereas, for Amazon, it is -18 days. Which company out of the two is doing better?
How to Interpret the Operating Cycle?
Please see the Operating Cycle Diagram.
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For eg:
Source: Operating Cycle (wallstreetmojo.com)
This cycle provides an insight on the operating efficiency of the company. This is useful in estimating the Cash cycle in a working capital requirement for maintaining or growing an organization’s operations. The shorter Cash cycle indicates that the company recovers its investments quicker and hence has less cash tied up in working capital. However, OC varies across industries, sometimes extending to more than a year for some sectors, for example, shipbuilding companies.
Gross vs. Net Operating Cycle
The gross operating cycle (GOC) is the time period after raw material purchases until its transformation to cash. As per the formula, the time can be divided into the inventory holding period and receivables collection period. Here inventory holding period comprises raw material holding period, work-in-process period, and finished goods holding period.
- GOC = Inventory Holding Period + Receivables Collection Period
- Or Gross OC = Raw Material Holding Period + Work-In-Process Period + Finished Goods Holding Period + Receivables Collection Period
Net Operating cycle (NOC) refers to the time period between paying for inventory and cash collected through the sale of receivables. It is also known as Cash conversion cycle (CCC)Cash Conversion Cycle (CCC)The Cash Conversion Cycle (CCC) is a ratio analysis measure to evaluate the number of days or time a company converts its inventory and other inputs into cash. It considers the days inventory outstanding, days sales outstanding and days payable outstanding for computation.read more.
- NOC = Gross Cycle-Creditor’s Payment Period
- The NOC is considered a more logical approach since payables are viewed as a source of operating cash or operating cycle in working capital for the company.
APPLE Operating Cycle Example (NEGATIVE)
Let us have a look at the Cash Cycle of Apple. We note that the cash cycle of Apple is Negative.
source: ycharts
- Apple Days Inventory Oustanding ~ 6 days. Apple has a streamlined product portfolio, and its efficient contract manufacturers deliver products quickly.
- Apple Days Sales Oustanding ~ 50 days. Apple has a dense network of retail stores, where they get paid mostly by Cash or Credit Card.
- Apple Days Payable Oustanding is ~ 101 days. Because of big orders to the suppliers, Apple is able to negotiate better credit termsCredit TermsCredit Terms are the payment terms and conditions established by the lending party in exchange for the credit benefit. Examples include credit extended by suppliers to buyers of products with terms such as 3/15, net 60, which essentially implies that although the amount is due in 60 days, the customer can avail a 3% discount if they pay within 15 days.read more.
- Apple Operating Cycle = 50 days + 6 days – 101 days ~ -45 days (Negative Cash cycle)
Example – L&T vs. Future Retail
Source: Annual Report FY17 of L&T Group and Future Retail
Download Excel for L&T Group vs Future Retail.
- As a standalone figure, this cycle does not mean much. Instead, it needs to be tracked over time and across competitors.
- In the case of L&T, the number has improved in FY17 over FY16 due to a decline in average inventoryAverage 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 and receivables, although sales and COGS have increased.
- A negative CCC means that L&T is getting paid by customers much earlier than payment to suppliers.
- This is an interest-free way of financing of operating cycle in working capital requirements by borrowing from suppliers. For Future Retail, DIO is much higher compared to L&T, since the former have to maintain higher inventory levels because of the nature of their business.
- The comparison of the Cash cycle across industries thus may not be feasible.
Conclusion
The operating cycle in working capital is an indicator of the efficiency in the management. The longer the cash cycle of a company, the larger is the working capital requirement. Hence, based on the duration of the Cash cycle, the working capital requirement is estimated by firms and financed by commercial banks. Reduction in Cash cycle helps in freeing up cash, thus improving profitability. The cash cycle can be shortened by extending payment terms of suppliers, maintaining optimum inventory levels, shortening production workflow, managing order fulfillment, and improving the accounts receivables process.
Video on Operating Cycle
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This has been a guide to what is Operating Cycle. Here we discuss operating cycle formula, its calculations along with practical examples of calculating the cash cycle of Apple, L&T Group, and Future retail. You may also have a look at these articles below to learn more about Corporate Finance –
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