Operating CycleThe average period of time it takes to convert inventory into cash

Patrick Louie
Last Updated: August 30, 2022
Date Published: August 30, 2022

Efficiency is an important aspect of any business.

The idea behind this is that the more efficient a business is, the more money it makes for every cent that it spends.

An efficient business will also have an easier time obtaining the money it needs to pay off its debts.

It could also mean that the business is great at selling its products.

The faster its products go to the hands of its customers, the faster it can make money.

This is why efficiency is one of the factors that investors gauge when investing in a business.

Efficiency is also important for creditors as they want to make sure that the business has enough money to pay for its debts when they become due.

So how does measure a business’s efficiency?

The fact is, there are many ways to measure a business’s efficiency.

And of them is to determine the business’s operating cycle.

To explain it briefly, the operating cycle is essentially the average amount of time a business needs to generate cash inflow from its initial investment in inventory.

In simpler words, it’s how fast the business makes money from the money it spends on purchasing inventory.

But that doesn’t explain everything, right? That is what this article is for.

In this article, we will be talking about what an operating cycle is.

How does it account for a business’s efficiency?

How does one calculate a business’s operating cycle?

What are the factors that affect a business’s operating cycle?

How can a business improve its operating cycle?

We will try to answer these questions as we go along with the article.

What is an Operating Cycle?

operating cycle 1

An operating cycle is the average amount of time that a business needs to convert its inventory into cash.

It can be separated into two sections: the time it takes to sell its inventory, and the time it takes to receive cash from its sales.

It starts from the time when the business acquires inventory and ends when it collects on its accounts receivable.

Naturally, a business that only does cash sales will have a shorter operating cycle.

On the other hand, inventory that naturally takes a long time to sell will result in a longer operating cycle.

An operating cycle is useful in estimating the minimum amount of working capital that the business will need to maintain its operations.

It also plays a significant role in gauging the efficiency of a business.

A short operating cycle may signify that the business is very efficient in converting its inventory into cash.

Since such a business only requires a short amount of time to acquire cash, it most probably will only need a small amount of working capital.

Additionally, even if such a business sells at relatively small margins, the speed at which it’s able to make a sale makes up for it.

On the other hand, a long operating cycle may signify that the business will take a significant amount of time to convert its inventory into cash.

It may be able to produce high profit margins, but due to the speed that it’s making money, it will need to maintain a significant amount of working capital just to maintain its operations.

Even more, if it wants to grow.

That being said, the ideal operating cycle will differ from business to business.

Some businesses from certain industries will naturally have a shorter or longer operating cycle.

The Operating Cycle Formula

The operating cycle formula is pretty straightforward as it only needs two components.

Here’s how it looks:

Operating Cycle = Inventory Period + Accounts Receivable Period

-or-

Operating Cycle = (365 ÷ (Cost of Goods Sold ÷ Average Inventory)) + (365 ÷ (Credit Sales ÷ Average Accounts Receivable))

Where:

Inventory Period – refers to the average amount of time that a business’s inventory sits in storage until sold. It could also refer to the average amount of time the business needs to sell its inventory

Accounts Receivable Period – refers to the average amount of time it takes for a business to collect cash from its sales. It could also refer to the average amount of time it takes for a business to convert its accounts receivable into cash

Essentially, an operating cycle is the sum of a business’s inventory and accounts receivable periods.

This is why I mentioned earlier that the operating cycle can be separated into two sections.

Now to better understand these two sections, let’s take a closer look at each of them.

Inventory Period

The formula for calculating the inventory period is as follows:

Inventory Period = 365 ÷ Inventory Turnover Ratio

Where:

Inventory Turnover Ratio – measures how many times a business is able to sell and replace its inventory over a certain period. It’s calculated by using this formula:

Inventory Turnover Ratio = Cost of Goods Sold ÷ Average Inventory

The inventory period is the average amount of time that inventory stays unsold.

It could also be viewed as the average amount of time it takes for a business to sell inventory.

The higher the inventory period is, the longer it takes for a business to sell its inventory.

Some inventory naturally takes a long time to sell though such as cars and other capital assets.

On the other hand, there’s inventory that naturally sells quickly such as essential goods.

As such, the standard inventory period will vary from industry to industry.

Accounts Receivable Period

The formula for calculating the accounts receivable period is as follows:

Accounts Receivable Ratio = 365 ÷ Receivables Turnover Ratio

Where:

Receivables Turnover Ratio– measures how many times a business is able to convert its receivables into cash.

It’s a numerical measure of a business’s efficiency in collecting cash from its accounts receivable.

It’s calculated by using this formula:

Receivables Turnover Ratio = Credit Sales ÷ Average Accounts Receivable

The accounts receivable period measures how long it takes for a business to collect cash from its sales, particularly its credit sales.

A business that solely does cash sales doesn’t have to mind this measurement.

The accounts receivable period also measures the business’s efficiency and strength in collecting cash from its accounts receivable.

A low accounts receivable period may signify that the business is great at collecting cash.

On the other hand, a high accounts receivable period may signify inefficiencies in the credit and collection policies of the business.

Factors that Affect the Operating Cycle

operating cycle

From the operating cycle formula, we can gather that there are two major factors that can affect a business’s operating cycle:

  • The amount of time it takes for the business to sell its inventory starting from the time it acquired such inventory; and
  • The amount of time it takes for the business to collect cash from its credit sales

By knowing these two factors, a business can know how to shorten its operating cycle:

Be able to sell its inventory relatively quickly

The time it takes to sell a particular inventory will differ from type to type.

Some inventories take a long time, while others take no time at all.

That being said, if a business is ahead of its competition regarding how long it takes for it to sell its inventory, it’ll probably have a relatively shorter operating cycle.

The faster a business is able to sell its inventory, the faster it’s able to receive cash from it.

Be able to collect cash from its receivables faster

This factor greatly depends on the strength of the business’s credit and collection policies.

The more effective they are, the greater the probability that a business can collect cash from its accounts receivable quickly.

The shorter the amount of time it takes to convert receivables into cash, the shorter the operating cycle will be.

FundsNet requires Contributors, Writers and Authors to use Primary Sources to source and cite their work. These Sources include White Papers, Government Information & Data, Original Reporting and Interviews from Industry Experts. Reputable Publishers are also sourced and cited where appropriate. Learn more about the standards we follow in producing Accurate, Unbiased and Researched Content in our editorial policy.

  1. Harvard Business School "WORD OF THE WEEK: CASH CONVERSION CYCLE" Page 1 . August 30, 2022