Let me first explain what is the operating cycle before I illustrate how to work it out. Every business wants to turn its inventory into cash as soon as possible. In order to improve cash flow and have the ability to do more sales in the same timeframe. To make customers happy, you should fulfil their order as soon as possible. Thereby processing more orders for more happy customers.
The operating cycle is the measure of time. The time it takes a business to get paid for a product or service after it receives the inventory or order for it. This also has a direct correlation to the amount of working capital that is needed in a business.
In order to work out your average operating cycle, you need to establish a few parameters. Firstly, the amount of time inventory sits in the store. Secondly, how long it takes the business to collect payment from its customers.
Operating cycle = Inventory period + Accounts receivable period
To calculate the Inventory period you need the direct cost of the goods sold and the average inventory value at a point.
Inventory period = 365/ (cost of goods sold / Average Inventory value)
To calculate accounts receivable period you need the total sales for the period and the average of accounts receivable.
Accounts receivable period = 365 / (Total Sales / Average Accounts Receivable)
So in order to improve the operating cycle, a business needs to speed up the sale of inventory and collect payment faster.
The Net Operating or Cash Conversion Cycle
Then we have another critical measurement which is known as the Net Operating Cycle as well as the Cash Conversion Cycle. This is the time the business needs to fund its operations or the number of days between paying suppliers and collecting from customers. This determines the efficiency of cash flow management and the longer the delay. The more cash flow a business needs to operate.
So, to reiterate, Net operating cycle is the length of time between paying for inventory and then collecting the cash from the sale.
The formula for determining this period is:
Cash conversion cycle = Operating cycle – Accounts payable period
To work out the Accounts Payable period, you need the total value of purchases for the year and the average of accounts payable (creditors).
Accounts payable period = 365 / (Total Purchases / Average Accounts Payable)
The shorter you can make the cycle, the less free cash flow you need.
This diagram should make it absolutely clear: