Understanding Operating Cycle
The operating cycle determines the time taken by the company's process of putting cash in operations and returning it to the cash account. It measures how long it is tied up in the Operating Cycle. The operating cycle defines the life cycle of cash used in operational activity. It follows the cash converted into inventory and then into the sale, then to account receivables are back to cash in hand. Essentially the operating cycle represents how quickly a company can convert the cash invested from the beginning (inventory investment) to the end (return as receivables).
The formula to derive Operating Cycle
Inventory Days -
Inventory Days is an Efficiency metric that indicates how many days it takes for a company to convert its inventory into sales. It is calculated as 365 days divided inventory turnover ratio.
Account Receivable Days -
It indicates the average number of days a company takes to settle invoices. It is calculated as 365 days divided by the account receivable turnover ratio.
Example of Operating Cycle:
For the financial year, Burger King India reported Inventory days as 12.12 and Account Receivable Days as 5.36.
The value as per the formula (Inventory Period + Account Receivable Period) is calculated as (12.12 + 5.36) = 17.48.
The operating cycle shows the period taken by the company's process of putting cash in operations and returning it to the cash account.
The operating cycle is the summation of inventory days and account receivable days.
Generally, short operating cycle is considered good as it indicates that the company requires fewer days to recover its inventory investment.
The operating cycle of the company includes the process of the company receiving inventory, selling the inventory, and collecting cash from the sale of it.
While looking at the Operating Cycle, the following points should also take into consideration:
A short operating cycle is considered good. It indicates that the company is efficient in recovering its investment in inventory quickly.
A long operating cycle of the company indicates that the company is taking a lot of days. But it does not necessarily mean bad as it changes from industry to industry. But in some cases, it may create cash flow problems for the company.
The operating cycle of the company includes the process of the company receiving inventory, selling the inventory, and collecting cash from the sale of it. And it measures how many days it takes for a company to convert its inventory into cash.
The operating cycle is the addition of inventory days and account receivable days. Inventory days measures the number of days required for the company to convert its inventory into sales, and account receivable days measures the number of days the company takes to settle its invoices.
This metric is important from the point of view of both the investors as well as the company to analyze how quickly the company is selling its inventory and converting it into cash. It indicates the efficiency of the company. This tool is also used internally by a company or its management to enhance its methods of collecting money from debtors.
How to use Operating Cycle effectively
The operating cycle differs from one industry to another, and also the policies may be dissimilar depending upon the industry. For better analysis, compare companies that operate in the same industry.
For better understanding, analyze historical annual and quarterly data to know the company's past performance. By analyzing historical performance, it will give a better picture of whether the company is maintaining its operational efficiency or not. To calculate the operating cycle, we need to calculate account receivable days
and inventory days
The Operating Cycle is only a part of the strategy while analyzing companies' fundamentals. For better analysis, we should check other financial metrics like Days in Working Capital
, Return on Equity (ROE)
, Return on Assets (ROA)