Operating Cycle

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What is the Operating Cycle?

The operating cycle, also known as the cash cycle of a company, is an activity ratio measuring the average period required for turning the company’s inventories into cash. This process of producing or purchasing inventories, selling finished goods, receiving cash from customers, and using that cash to purchase/produce inventories again is a never-ending cycle, as long as the company remains in operation.

As we see below, the Cash Cycle of Toyota Motors is 96 days, whereas, for Amazon, it is -18 days. So which company out of the two is doing better?

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Operating-cycle

How to Interpret the Operating Cycle?

Please see the Operating Cycle Diagram. 

Operating Cycle

This cycle provides an insight into the operating efficiency of the company. This is useful in estimating the Cash cycle in a working capital requirement for maintaining or growing an organization’s operations. The shorter Cash cycle indicates that the company recovers its investments quicker and hence has less cash tied up in working capital. However, OC varies across industries, sometimes extending to more than a year for some sectors, for example, shipbuilding companies.

Video on Operating Cycle

Gross vs. Net Operating Cycle

The gross operating cycle (GOC) is the period after raw material purchases until their transformation to cash. As per the formula, the time can be divided into the inventory holding period and receivables collection period. Here inventory holding period comprises the raw material holding period, work-in-process period, and finished goods having a period.

  • GOC = Inventory Holding Period + Receivables Collection Period
  • Or Gross OC = Raw Material Holding Period + Work-In-Process Period + Finished Goods Holding Period + Receivables Collection Period

The Operating net cycle (NOC) refers to the period between paying for inventory and cash collected through the sale of receivables. It is also known as Cash conversion cycle (CCC).

  • NOC = Gross Cycle-Creditor’s Payment Period
  • The NOC is considered a more logical approach since payables are viewed as a source of operating cash or operating cycle in working capital for the company.

APPLE Operating Cycle Example (NEGATIVE)

Let us have a look at the Cash Cycle of Apple. We note that the cash cycle of Apple is Negative.

Apple-Negative-Cash-Conversion-Cycle

source: ycharts

  • Apple Days Inventory Oustanding  ~ 6 days. Apple has a streamlined product portfolio, and its efficient contract manufacturers deliver products quickly.
  • Apple Days Sales Oustanding ~ 50 days. Apple has a dense network of retail stores, where they get paid mostly by Cash or Credit Card.
  • Apple Days Payable Oustanding is ~ 101 days.  Because of big orders to the suppliers, Apple is able to negotiate better credit terms.
  • Apple Operating Cycle = 50 days + 6 days – 101 days ~ -45 days (Negative Cash cycle)

Example - L&T vs. Future Retail

Operating Cycle of L&T

Source: Annual Report FY17 of L&T Group and Future Retail

Download Excel for L&T Group vs Future Retail.

  • As a standalone figure, this cycle does not mean much. Instead, it needs to be tracked over time and across competitors.
  • In the case of L&T, the number has improved in FY17 over FY16 due to a decline in average inventory and receivables, although sales and COGS have increased.
  • A negative CCC means that L&T is getting paid by customers much earlier than payment to suppliers.
  • This is an interest-free way of financing the operating cycle in working capital requirements by borrowing from suppliers. For Future Retail, DIO is much higher than L&T since the former have to maintain higher inventory levels because of the nature of their business.
  • The comparison of the Cash cycle across industries thus may not be feasible.

Conclusion

The operating cycle in working capital is an indicator of the efficiency in the management. The longer the cash cycle of a company, the larger the working capital requirement. Hence, based on the duration of the Cash cycle, the working capital requirement is estimated by firms and financed by commercial banks. Reduction in the Cash cycle helps free up cash, thus improving profitability. The cash cycle can be shortened by extending suppliers' payment terms, maintaining optimum inventory levels, shortening production workflow, managing order fulfillment, and improving the accounts receivables process.