The operating cycle is the time in days between buying inventory from a supplier and receiving the cash from the sale of that inventory from a customer. The length of the cycle will vary from business to business depending on the industry in which it operates.
As an illustration, a manufacturing business will buy raw materials, hold them as inventory, convert them into finished products for sale, sell the products on credit, and finally receive the cash from the customer. The diagram below summarizes the process.
Operating Cycle Formula
The operating cycle formula is used to calculate the number of days as follows:
Inventory days is the average number of days inventory held in the business and can be calculated using our inventory days calculator. Accounts receivable days is the average number of days credit taken by customers, and can be calculated using our accounts receivable days calculator.
Operating Cycle Example
To illustrate suppose a business buys inventory and it stays in the warehouse for 45 days before it is sold on 60 day credit terms to a customer. In this situation the calculation of the cycle is as follows:
Operating cycle = Inventory days + Accounts receivable days Operating cycle = 45 days + 60 days = 105 days
As shown above on average there are 105 days between buying inventory and receiving cash from the sale of that inventory. As can be seen the longer the inventory holding period and the longer the time it takes customers to pay, the longer the operating cycle of the business will be.
Assuming no credit is given by the supplier, this has serious implications for the cash flow of the business, as the inventory has to be funded from internal cash resources or from additional financing during this period.
If for example, the value of the inventory purchased was 75,000, and interest rates are 6%, then the interest charge (or lost interest if using cash) is given by
Interest = 75,000 x 6% x 105 / 365 Interest = 1,295
Clearly, the shorter the operating cash cycle the lower the finance costs will be. A long cycle means cash is tied up in inventory and money due from customers (accounts receivable).
A business should aim to have as short an operating cycle as possible by reducing the need to hold inventory for long periods of time, and by shortening customer credit terms or by improving cash collections from outstanding accounts.
The operating cycle should be regularly monitored to ensure that it is at appropriate levels for the industry, and that the level is not rising. To help with this our financial projections template, calculates the operating cycles on the ratios page.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.