Every business must learn to keep the time it takes to recover cash used to purchase inventory. Failure to do so may by default lead to inability to meet present obligations and operational needs. Such as buying fuel in the entity’s generator. In this article you will learn what Gross Operating Cycle (GOC) is about and how to calculate it.
Definition — What is Gross Operating Cycle
It is the number of days it takes to make or purchase inventory and sell the same to customers on credit terms. It can also be defined as the inventory conversion period plus Account Receivable (debtors) conversion period. This is the period of time to purchase and store inventory and deliver it to customers.
Number of days. Gross Operating Cycle deals with the number of days. At times, weeks or months may be used. But this depends on the nature of the industry concerned. And it’s norms. For trading and manufacturing businesses, numbers of days are mostly used.
Make inventory. For manufacturing entities, raw materials have to be purchased. Next, transformed to inventories that will be sold to its customers. In such a case, the inventory conversion period includes Raw Material Conversion period, Work-in-Progress Conversion period and Finished Goods Conversion period.
Purchase of Inventory. For non-manufacturing firms, there is no requirement for making a product. The goods can be purchased from a manufacturer or wholesaler and sold to final consumers. In this case, the inventory conversion period is easier to calculate.
Sell to Customers. Next the inventory is sold to customers. Here, every effort must be made to ensure that goods are sold. Failure to do so may increase the inventory conversion period. Therefore, implying poor marketing strategies.
Cash or Credit terms. In calculating gross Operating Cycle, only goods sold on credit terms are necessary. This is true as cash sales means that the money is already available to meet operational expenses, buying of additional inventories and paying debts. However, cash must be collected from items sold on credit.
This will affect the Account Receivable conversion period. A high period means the entity has loosened credit policy or lacks an effective recovery team. Otherwise, implies a strict credit policy and better collection process.
Formula for Calculating Gross Operating Cycle
The formula for GOC is Inventory Conversion Period + Account Receivable conversion period. The lower the period the better for the entity in meeting present working capital needs.
Inventory conversion period for non manufacturing firms is Average Inventory ÷ Cost of goods sold × 360 (days/weeks/months).
Average Inventory is (Opening + Closing Inventory) ÷ 2.
Account Receivable conversion period is Average Account Receivable ÷ Credit Sales × 360 (days/weeks/months).
Average Account Receivable is (Opening + Closing Account Receivable) ÷ 2.
Below is an abstract of the Computer Warehouse Group (CWG) financial statement (FS) for 2021. The company is listed in the Nigerian Stock Exchange. From the FS we can calculate the Gross Operating Cycle for the firm for 2020.
Remember, GOC = Inventory Conversion Period + Account Receivable Conversion Period
Inventory conversion period is Average Inventory ÷ Cost of Sales × 364 days
From the financial statements abstract, Average Inventory is (585,515 + 773,947) ÷ 2. This gives 679,731. And the cost of sales is 9,080,002. The Inventory Conversion Period is 679,731 ÷ 9,080,002 × 365 days. Which equals 27.3 Days.
Next, we calculate Account Receivable conversion period. Which is Average Account Receivable ÷ Credit Sales × 365 Days.
Average A/C Receivable is (5,299,040 + 5,550,695) ÷ 2. This gives 5,424,867.5. The cost of sales for CWG is 11,715,819. The Account Receivable conversion period is 5,424,867.5 ÷ 11,715,819 × 365 Days. This gives 169 Days.
Now, the Gross Operating Cycle for CWG is 27.3 Days + 160 Days. This is a total of 187.3 Days.
Note also that the credit sales used for CWG combined cash and credit sales. The reason was that it wasn’t possible to get the actual credit sales from CWG’s Annual Report for 2020.
Gross Operating Cycle is the number of days it takes to make or purchase and sell inventory to customers. It is the addition of inventory conversion period and account receivable conversion period. It is simple to calculate GOC. In this article, we calculated it from Computer Warehouse Group Financial Statements. A company listed in the Nigerian Stock Exchange market.