May 22, 2021

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Operating Cycle Explanation and Formula

Operating Cycle Explanation and Formula

What is an operating cycle?

The operating cycle in accounting is the period (number of days) from the moment the raw materials arrive at the warehouse until the receipt of payment for the products sold. This is an important part of running a business. You buy some goods and then you sell them and then you collect on that sale.

The operating cycle allows determining the position of an enterprise in the industry, changes in its solvency, and financial position. It is considered one of the most effective indicators for assessing the effectiveness of working capital management.

Operating Cycle Explanation and Formula

The shorter the operating cycle, the more times we can turn around our assets, and the more profits we can earn. After all, each turnover of assets brings a financial result in the form of profit for the reporting period. This, in turn, determines whether the business will be able to attract investments or not.

For example, when a clothing store buys another batch of dresses, it often manages to receive proceeds from their sale within a few weeks. When a car assembly plant buys raw materials, it will not be able to receive revenue for finished cars for a few months. This difference in periods between the purchase of materials and the sale of final products is determined by the operating cycle.

Calculation

The duration of the operating cycle is calculated as the sum of the inventory period, which is from the time you buy it to the time you actually sell it, and the accounts receivable period, which is the time it takes to collect on receivables. Let’s look at an example.

Suppose Kids Shoes company purchase $2,600 worth of inventory on Day 0 using credit. The inventory should be paid within 30 days and the company pays the bill 30 days later. After 20 more days, someone buys the $2,600 in inventory for $3,500. The Kids Shoes company give this buyer 15 days to pay for the purchase and they took 10 days to pay. What is the operating cycle for this company?

The operating cycle is that entire period of 60 days. The inventory period equaled 50 days – from the day the company purchased the inventory to the day it was sold. The accounts receivable period is the amount of time from the sale until the company got paid and it took 10 days to get paid for the shoes sold.

Operating Cycle Explanation and Formula

The inventory period can also be found by taking 365 days and dividing by inventory turnover. Turnover is how many times a year that the average amount of inventory, receivables, or payables are sold, recovered, or paid. Thus, inventory turnover is calculated by dividing the COGS by the average inventory, which is the amount of inventory that is typically held at any one time.

If the average inventory, for instance, is $200K and the Profit and Loss Statement shows the COGS of $600K, we can see that the business managed to sell the inventory three times over during the year. In order to get our inventory period, we can say that it took the company 1/3 of a year to sell the average inventory or 365 / 3 = 122 days

You can apply the same logic to the accounts receivable period calculation, using the total credit sales for the whole year when computing the turnover number. You will get how many times a year that average AR are recovered.

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Author: Charles Lutwidge

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