To have operational efficiency, adequate working capital is important. This results in the need to monitor the business operating cycle. If a firm wants to reduce liquidity risk, then OC is one analysis tool to utilize. What’s this about? What happens if management fails to keep a close eye on it?
Definition of Operating Cycle
It can be defined as the average period between which a firm purchased raw materials, converted it and sold them for cash. This definition applied to manufacturing firms. For trading firms, we can define an operating cycle as the time duration to sell inventories already purchased for cash.
Average period of time. It is all about a time duration. Operating cycle adds up the average time for inventory plus that of account receivable. This is the operating cycle formula. Here, the entity’s management is considering the period it takes to purchase inventory. And sell such inventory either by cash or on credit. Cash is collected later from inventories sold on credit.
Purchase of Inventories. Before cash is collected, the business will stock inventories. This required funding! Therefore, the business may seek credit purchases or pay for the goods immediately. When goods are purchased on credit, the debt must be paid in due time. And cash is needed for it.
When the credits are paid, it is referred to as the net operating cycle or cash conversion cycle. In this OC, the account Payable collection period is deducted from the operating cycle formula as already explained. Inventories include raw materials, work in progress and finish items.
Acquisition of other resources. The cash collected from sales is also required to buy fuel, pay wages and salary, acquire stationeries and maintain the plant, machines and equipment of the firm.
Sales of inventories for cash or credit. Next, the Inventories are sold for cash or on credit bases. When it is sold on cash the OC is complete. However, credit sales will prolong the cycle and the business owner must do all it can to get cash from debtors. When this is achieved, it completes the operating cycle.
Why is business owners and managers concern about operating cycle
It helps keep check on liquidity. Operating Cycle (OC) enables business management to understand its liquidity. A short OC tells the owner that the business can pay off debts as they fall due. However a long one is a sign that debts may be difficult to repay on time.
It explains business operating efficiency. If a business sells its inventories on time. Then, it has operational efficiency. This means that all hands were on deck to ensure that the firm’s items were sold on time and receivables are collected as soon as it is due.
Operational inefficiency explains that the OC is longer than expected. Therefore, the firm lacks adequate skills to sell its products and collect debts repayments from debtors.
It makes clear the firm’s credit policy. A short OC tells you that the business has strong and strict credit policy that is complied with by debtors. But a weak policy is exposed from a long operating cycle. A strict credit policy means that receivables are collected on time. It also means that credits are not given to customers unless they meet certain criteria.
From this article, it is clear that the operating cycle is the average time it takes a business to convert inventory to cash. A short OC means the firm is efficient and has less liquidity risk but a longer one reveals poor credit policy. The periods for an operating cycle depends on the type of Industry. A trading firm will have a shorter cycle than a construction business.