Operating cycle refers to the delay between the buying of raw materials and the receipt of cash from sales proceeds. In other words, operating cycle refers to the number of days taken for the conversion of cash to inventory through the conversion of accounts receivable to cash.It indicates towards the time period for which cash is engaged in inventory and accounts receivable. If an operating cycle is long, then there is lower accessibility to cash for satisfying liabilities for the short term.Operating cycle takes into consideration the following elements: accounts payable, cash, accounts receivable, and inventory replacement.
The following is the operating cycle formula:
Operating cycle = age of inventory + collection period
Age of Inventory (in days) = Inventory/ (Cost of Sales/365) = 365/Inventory Turnover
Collection Period (in days) = Receivables/ (Sales/365) = 365/Receivables Turnover
Cash cycle is also termed as net operating cycle, asset conversion cycle, working capital cycle or cash conversion cycle. Cash cycle is implemented in the financial assessment of a commercial enterprise. The more the figure is increased, the higher is the period for which the cash of a commercial entity is engaged in commercial activities and is inaccessible for other functions, for instance investments.
The cash cycle is interpreted as the number of days between the payment for inputs and getting cash by sales of commodities manufactured from that input. The fundamental formula that is applied for the calculation of cash conversion cycle is as follows:
= (Average Stockholding Period) + (Average Receivables Processing Period) – (Average Payables Processing Period)
Average Receivables Processing Period (in days) = Accounts Receivable/Average Daily Credit
Sales Average Stockholding Period (in days) = Closing Stock/Average Daily Purchases
Average Payable Processing Period (in days) = Accounts Payable/Average Daily Credit Purchases
A short cash cycle reflects sound management of working capital. On the other hand, a long cash cycle denotes that capital is occupied when the commercial entity is expecting its clients to make payments.
There is always a probability that a commercial enterprise can face negative cash conversion cycle, in which case they are getting payments from the clients before any payment is made to the suppliers. Instances of such business entities are commonly those companies, which apply JIT or Just in Time techniques, for example Dell, as well as commercial enterprises, which purchase on terms and conditions of longer duration credits and perform sales against cash, for instance Tesco.
The more the manufacturing procedure is extended, the higher the amount of cash should be kept engaged in inventories by the company. Likewise, the more time is taken for the clients for the purpose of bill payment, the more is the accounts receivable amount. From another viewpoint, if a company is able to detain the payment for its internal inputs, it can decrease the amount of money required. Put differently, the net working capital is diminished by accounts payable. Thus, Operating cycle and cash cycle determine the efficiency of a firm regarding working capital management.