Operating Cycle
What is Operating Cycle and how does it affect the Working Capital needs?
The Operating Cycle of a company refers to the time which is needed to complete all the steps in the manufacturing process. The operational process starts with the spending of cash for the purchase of raw materials. And the process ends with the sale of finished products (and the realization of payment).
To execute the manufacturing process, the cash and other assets of the company get locked into the operations. The cash is only retrieved at the end of the manufacturing process, when the goods have been sold. So, the time period between the purchase of inventory and the cash inflow after the sale is called the Operating Cycle.
The duration of this cycle will depend on the type and nature of the product and the manufacturing policies. Usually, the completion time period of 1 manufacturing cycle will be considered for the calculation of the Operating Cycle. So, a company could have multiple such cycles in a calendar year.
Operating Cycle example
Suppose that a pharmaceutical company buys chemicals and converts them into medicines. The Working Cycle of this business would start with the company spending cash for acquisition of raw material. The purchase could have been made on Credit or by payment of cash, right away.
Next, the purchased ingredients have to be processed for making the medicines. The company might need to spend more cash on operational expenses like electricity, water, worker wages etc. Finally, the medicines will be sold in the market and the sale could be done on Credit or on Cash basis.
There is a time gap between the initial cash outflow and the inflow. So, it becomes important to accurately measure this time period, as it helps in planning for the operations. It should make inherent sense that if this cycle is long, then more short-term assets of the company will get tied up in the operations. Therefore, a shorter Operating Cycle is preferable for running the business smoothly.
Operating Cycle formula
In order to define Operating Cycle, we would first need to understand the components that make up this cycle. The time duration of this cycle will depend on the time taken to complete the different stages of manufacturing.
Depending on the method of calculation, there are two ways to calculate Operating Cycle:
Gross Operating Cycle
The Gross method of calculating the Operating Cycle includes the addition of all the Conversion Periods of the different stages of operation. This method of measurement can be summarized by the below-mentioned Gross Operating Cycle formula:
\(OC_g = RM + WIP + FG + BD\)Where,
\(RM\): Raw Material Conversion Period. This is the average time period for which the raw materials are held in inventory.
\(WIP\): Work in Progress Conversion Period. This is the time period which is required to convert the raw materials into finished goods.
\(FG\): Finished Goods Conversion Period. This is the average time period for which the Finished Goods are held in inventory.
\(BD\): Book Debts. This is the Credit Period that is given by the company to the buyers of finished goods to make the payment.
Net Operating Cycle
The Net method of calculating the Operational Cycle will also consider the Credit Period that the company receives from the suppliers. Since the received Credit Period will delay the cash outflow from the company, it can be deducted from the Raw Material Conversion Period. The Net Operating Cycle is also known as the Cash Conversion Cycle, because it tracks the cash inflow and outflow.
So, the gross formula mentioned above can be adjusted to get the Net Operational Cycle formula:
\(OC_n = (RM – CP) + WIP + FG + BD\)Where,
\(CP\): The Credit Period that the company receives from the suppliers of raw materials.
Impact on Working Capital requirements
Working Capital refers to the financial resources that are needed to perform the daily activities of a business. So, it is the amount of money that is tied up in the Current Assets and Current Liabilities, which deal with the manufacturing process.
If the manufacturing cycle of a product is long, then the financial resources get locked in for a longer duration. Similarly, if the cycle is short, then the resources will be blocked for a shorter duration. Therefore, the Operating Cycle of Working Capital is an important factor in Working Capital Determination.
Example: Suppose that Company X keeps excessive raw materials in the warehouse and they stay in the Inventory for 6 months, before they are issued for production. On the other hand, suppose that a similar Company Y maintains low inventory and for them, the raw materials stay in Inventory for 1 month, before consumption.
In this example, the Cash of Company X is tied up in the Permanent Working Capital for: 6 months + duration of other manufacturing activities. So, Company X would require more funds than Company Y to complete the entire Working Capital Cycle.
Management of Working Capital
Working Capital Management refers to the analysis and maintenance of the short-term financial resources of a business. It is an important aspect of running the operations smoothly and there are primarily two ways to do it:
- Standard Method
- Operating Cycle method
In the Standard method, the individual constituents of the Working Capital like Inventory, Cash, Receivables etc. are managed separately. So, there are different management policies for each of these components.
But when the Operating Cycle is used for management purposes, then the optimum level of Working Capital is decided by referring to the expenses for completing 1 Operational Cycle. To calculate the Working Capital requirements, the cost associated with the different time periods of the Operational Cycle has to be calculated.
Disclaimer
- This page is for education purpose only
- Some information could be outdated / inaccurate
- Investors should always consult with certified advisors and experts before taking final decision
- Some images and screenshots on this page might not be owned by FinLib