Operating Cycle

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?

Operating-cycle

How to Interpret the Operating Cycle?

Please see the Operating Cycle Diagram. 

Operating Cycle

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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.

Apple-Negative-Cash-Conversion-Cycle

source: ycharts

Example – L&T vs. Future Retail

Operating Cycle of L&T

Source: Annual Report FY17 of L&T Group and Future Retail

Download Excel for L&T Group vs Future Retail.

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

Recommended Articles

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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