What is the Operating Cycle?

How to Interpret the Operating Cycle?

Please see the Operating Cycle Diagram. 

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This cycle provides an insight into 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 period after raw material purchases until their 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 the raw material holding period, work-in-process period, and finished goods having a period.

  • GOC = Inventory Holding Period + Receivables Collection PeriodOr Gross OC = Raw Material Holding Period + Work-In-Process Period + Finished Goods Holding Period + Receivables Collection Period

The Operating net cycle (NOC) refers to the 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 PeriodThe 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 portfolioProduct PortfolioA product portfolio refers to the complete list of products offered by a company.read more, 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 the operating cycle in working capital requirements by borrowing from suppliers. For Future Retail, DIO is much higher than 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 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 the Cash cycle helps free up cash, thus improving profitability. The cash cycle can be shortened by extending suppliers’ payment terms, maintaining optimum inventory levels, shortening production workflow, managing order fulfillment, and improving the accounts receivables processAccounts Receivables ProcessThe Accounts Receivable Process is divided into four steps: 1) The company’s credit practices for customers must be determined. 2) Invoice them for the goods sold to them. 3) Keep track of the payments that have been received and those that have yet to be received. 4) The Accounts Receivable balances are recorded by the accounts department.read more.

Video on Operating Cycle

This has been a guide to what the operating cycle is. Here we discuss the operating cycle formula and 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 –

  • Cash Conversion CycleCash Conversion CycleThe 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 moreCash Coverage RatioCash Coverage RatioCash Ratio is calculated by dividing the total cash and the cash equivalents of the company by total current liabilities. It indicates how quickly a business can pay off its short term liabilities using the non-current assets.read moreCarriage InwardsCarriage InwardsCarriage inwards, also known as freight inwards, is the cost of transporting goods from a warehouse to the buyer’s business location, and it is treated as a direct expense. As a result, it is always reflected on the trading account’s debit side.read more