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How to Calculate Operating Cycle of a Bank?
What is an Operating Cycle?
An operating cycle is the time needed to convert sales into cash after converting the resources into inventories. In fact, no company generates sales after the production of a good instantly. It has to wait for some time to sell the goods in the market after purchasing raw materials and other necessary items and producing the finished goods.
The operating cycle of a manufacturing company has the following three phases −
Acquisition of resources − This is the beginning phase where raw materials used for the finished products are resourced and collected.
Manufacturing of the product − This is the phase where the raw materials are converted to finished goods. Fixed assets are used to get the finished product in this phase.
Sales of finished goods − Sales can be made either for cash or credit. Credit sales of assets create accounts receivable. For an operating cycle, sales are the most important part because the time duration of sales determines the operating cycle.
These three phases cause cash flows that are neither certain nor smooth. Resourcing of raw materials causes cash outflow and the company must pay for the stock of raw materials so that it can meet the demands without interruption in production. Sales of finished goods create cash inflow which is very uncertain because determining the payment from clients cannot be pre-assumed.
Calculation of Operating Cycle of a Bank
It is generally observed that the operating cycle of a manufacturing cycle is different from the financial firms, such as banks and Non-Banking Financial Companies (NBFCs). This difference in the calculation of the operating cycle is derived from the nature of their businesses. They are as described below.
Cash Acts as Inventory
While manufacturing companies are involved in the production of goods, financial firms usually do not get engaged in production directly. They may assist firms in producing goods, but this cannot be considered the bank’s responsibility. Therefore, the banks usually have no inventories and cash acts as inventory for them.
The operating cycles of banks are the shortest due to the above-mentioned reason. As they have no inventories, they do not need to convert raw materials into work in process and then into cash. They use cash as inventory to create debtors to whom they lend the money and then they convert these debtors into cash.
No Reliance on Inventory
As banks do not rely on inventory, calculating the net operating cycle instead of the gross operating cycle is handier for them. They need to consider the cash deferral period and deduct it from the total operating cycle to get the net operating cycle. Banks do not need to consider inventories and hence in calculating the total operating cycle or gross operating cycles, the total time taken to create debtors is considered helpful.
Net Operating Cycle = Gross Operating Cycle − Deferred Cash Period
Rely On Cash Directly
Another reason why calculating the operating cycle of a bank is easier than manufacturing companies is that banks and other financial services organizations rely on cash directly. They do not spend the money to resource raw materials instead of using the cash directly, by loaning them to other firms. The firms acquire this cash and use it in their own operating cycles.
No Requirement for Long-term Assets
A bank’s business policy is different from that of a manufacturing company. The manufacturing company needs fixed assets and they consider these assets in the calculation of operational efficiency in the long run. A bank does not need long-term assets. Its assets are the financial tools, such as cash and hence they consider calculating cash to judge the operational efficiency.
Therefore, banks are more efficient in calculating operating cycles for their operational efficiency. As manufacturing companies need to rely on various factors to determine the value of their fixed assets, their operational efficiency is considered lower than banks and other financial companies. So, the operational efficiency and clear-cut mechanism help financial institutions calculate the operating cycle more easily.
No Need to Convert Sales into Cash
The banks also do not need to convert sales into cash. They have the cash already and they just need to use the cash to increase when they consider the operating cycles.
One of the most notable outcomes while considering operating cycles is to increase the profitability from one to the next operating cycle. While this is a lengthier process for manufacturing companies, the banks rely on shorter paths to achieve their goals. Having shorter operating cycles help banks remain intact in their operations to collect and grow their assets.
As the banks have shorter operating cycles, they get more opportunities to grow their base of assets than manufacturing companies. However, the rates of return in the case of banks in each operating cycle are lower than manufacturing companies. That is why even when the operating cycle is longer, the profitability of manufacturing firms is often better than that of banks and other financial companies.
It is notable here that both banks and manufacturing companies rely on their internal resources to shorten the operating cycles to get back the cash they infuse in the preliminary steps of the operating cycle. Therefore, although the process of achieving the targets are different, both types of organization have common goals to get the maximum cash out of their operating cycles.
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