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What is Operating Cycle?
The operating cycle (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 above, Cash Cycle of Toyota Motors is 96 days, whereas, Cash Cycle of Amazon is -18 days. Which company out of the two is doing better?
Learning about the Cash Cycle will help us find the right answer.
Operating Cycle Diagram (Cash cycle)
This cycle provides an insight on the operating efficiency of the company. This is useful in estimating the Cash cycle in working capital requirement for maintaining or growing an organization’s operations. Shorter Cash cycle indicate that 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
Gross operating cycle (GOC) is the time period after raw material purchase till its transformation to cash. As per operating cycle formula, the time can be divided into 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.
- Gross Operating Cycle Formula = 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).
- Net Operating Cycle Formula = Gross Operating Cycle-Creditor’s Payment Period
- The net OC 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.
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Operating Cycle Calculation
NOC (days)= Days Inventory Outstanding (DIO) + Days Sales Outstanding (DSO) – Days Payable Outstanding (DPO)
#1 – Days Inventory Outstanding
Days inventory outstanding is the average number of days required for the company to convert its inventory into sales. A lower DIO speaks of the efficient use of the inventory since it signifies lower holding period and little chance of inventory becoming obsolete. Automobile companies usually maintain just-in-time production system by maintaining minimum inventory levels and thus lower DIO. However, some companies may choose higher DIO to service customer orders at a shorter time and thus maintain a competitive niche.
- DIO= 365/Inventory Turnover
Where, Inventory Turnover= Annual Cost of Goods Sold /Average Inventory cost
and Average Inventory Cost= (Beginning of the year inventory + End of year inventory)/2
The average figure is taken for all Balance Sheet items while computing this Cycle to maintain consistency between numerator and denominator which have both income statement and balance sheet items. While income statement measures activities for the whole year, balance sheet provides the value of the item as on a particular day.
DIO can be broken up into raw material holding period, work-in-process period and finished goods holding period.
- Raw Material Holding Period = 365*(Average raw material inventory)/ (Annual consumption of raw material)
- Work-In-Process Period= 365* (Average work-in-process inventory)/ (Annual cost of goods sold)
- Finished Goods Holding Period=365*(Average finished goods inventory)/(Annual cost of goods sold)
#2 – Days Sales Outstanding
Days Sales Outstanding or receivables collection period is the average number of days taken by a company to collect cash from its credit sales. It gives an indication of the efficiency of the collection department and the bargaining power of the seller. While lower DSO increases the cash flow and liquidity, higher DSO may indicate less aggressive credit terms to boost sales but could run the risk of higher bad debts.
- DSO=365/Receivables Turnover
Where Receivables Turnover=Net Credit Sales/Average Accounts Receivable
#3 – Days Payable Oustanding
Days Payable outstanding or the creditor’s payment period is the average number of days taken by a company to pay its invoices from trade creditors. DPO gives an indication of the efficiency in cash flow management of a company. While longer payment periods would leave higher free cash flow with the company, future credit terms may be less favorable for the company and discounts for timely payments may not be available. If DPO of a company is lower than industry benchmark, that would indicate that the company is not using its cash as efficiently as its competitors.
- DPO=365/Payables Turnover
Where Payables Turnover=Cost of Goods Sold/Average Accounts Payable
APPLE Operating Cycle Example (NEGATIVE)
Let us have a look at the Cash Cycle of Apple. We note that cash cycle of Apple is Negative.
- Apple Days Inventory Oustanding ~ 6 days. Apple has a streamlined product portfolio and their 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 terms.
- Apple Operating Cycle Formula = 50 days + 6 days – 101 days ~ -45 days (Negative Cash cycle)
Operating Cycle Calculation Example – L&T vs Future Retail
Source: Annual Report FY17 of L&T Group and Future Retail
- As a standalone figure, this cycle does not mean much. Instead, it needs to be tracked over time and across competitors.
- In case of L&T, the number has improved in FY17 over FY16 due to decline in average inventory 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 Cash cycle across industries thus may not be feasible.
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 its operating cycle in working capital requirement. Hence, based on the duration of Cash cycle, the operating cycle in working capital requirement is estimated by firms and financed by commercial banks. Reduction in Cash cycle helps in freeing up cash thus improving profitability. cash cycle can be shortened by extending payment terms of suppliers, maintaining optimum inventory levels, shortening production workflow, managing order fulfillment and improving the receivables collection process.
This has been a guide to what is Operating Cycle. Here we discuss operating cycle formula, its calculations along with practical examples of calculating 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 –