Question

What is the meaning of the term the operating cycle? Is the operating cycle the same length for all businesses? What factors affect the operating cycle?

Answer 1

Operating cycle is the average time period required by a business to convert its available cash into inventory, sell this inventory to customers and recieve cash in return. An operating cycle is the amount of time a company spends between spending money on operating activities and collecting money from the same operating activity. An Operating Cycle also refers to the days required for a business to receive inventory, sell the inventory, and collect cash from the sale of the inventory. The formula is as follows:

Operating Cycle = Days' Sales of Inventory + Days Sales Outstanding

No, the operating cycle is not the same length for all the businesses. In a manufacturing firm, the operating cycle is longer as more time is required to procure raw materials, converting raw materials into finished goods and converting finished goods into sales and ultimately into cash. In a trading business or a reselling business operating cycle is shorter.

Factors affecting operating cycle:

1. Industry - A construction company will have a longer operating cycle than a retail business.

2. Liquidity - the higher the liquid assets, the shorter the operating cycle.

3. Management efficiency - The less efficient the management of a firm, the longer the operating cycle and vice versa.