Operating Cycle
Operating cycle refers to number of days a company takes in converting its inventories to cash. It equals the time taken in selling inventories (days inventories outstanding) plus the time taken in recovering cash from trade receivables (days sales outstanding).
Length of a company's operating cycle is an indicator of the company's liquidity and asset-utilization. Generally, companies with longer operating cycles must require higher return on their sales to compensate for the higher opportunity cost of the funds blocked in inventories and receivables.
It is called operating cycle because this process of producing/purchasing inventories, selling them, recovering cash from customers, using that cash to purchase raw materials to produce more inventories and so on is repeated as long as the company is in operations.
A related concept is that of net operating cycle which is also called the cash conversion cycle. The net operating cycle subtracts the days a company takes in paying its suppliers from the sum of days inventories outstanding and days sales outstanding.
When there is a significant different between current ratio and quick ratio, it is useful to study the operating cycle and cash conversion cycle to ascertain whether the company’s funds are less-profitable assets.
Formula
Operating cycle can be calculated using the following formula:
Operating Cycle = DIO + DSO
Where DIO and DSO stand for days inventories outstanding and days sales outstanding, respectively. Days inventories outstanding equals the average number of days in which a company sells its inventory. Days sales outstanding, on the other hand, is the average time period in which receivables pay cash.
Net operating cycle (also called cash conversion cycle) equals operating cycle minus days payable outstanding (DPO):
Net Operating Cycle = DIO + DSO - DPO
Example
Walmart Stores Inc. (NYSE: WMT) is all about inventories. Find its operating cycle assuming all sales are (a) cash sales and (b) credit sales. You can use cost of revenue as approximate figure for purchases (i.e. no need to adjust it for changes in inventories).
| USD in million | |
|---|---|
| Revenue | 469,162 |
| Cost of revenue | 352,488 |
| Inventories as at 31 January 2013 | 43,803 |
| Inventories as at 31 January 2012 | 40,714 |
| Average inventories | 42,259 |
| Accounts receivable as at 31 January 2013 | 6,768 |
| Accounts receivable as at 31 January 2012 | 5,937 |
| Average accounts receivable | 6,353 |
Solution
Part (a)
Days taken in converting inventories to accounts receivable = 365 ÷ 352,488 × 42,259 = 43.75
Since there are no credit sales, time taken in recovering cash from accounts receivable is zero. Customers pay cash right away.
Operating cycle is 43.75 days, and this represents the time taken solely in selling inventories.
Part (b)
There is no change in days taken in converting inventories to accounts receivable.
Days taken in converting receivables to cash = 365 ÷ 469,162 × 6,353 = 4.92
Operating cycle
= days taken in selling (DIO) + days taken in recovering cash (DSO)
= 43.75 + 4.92 = 48.68
It should be compared with operating cycle of Walmart Competitors, like Amazon, Costco, Target.
by Obaidullah Jan, ACA, CFA and last modified on