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What is Operating Cycle in Finance?
What is Operating Cycle?
All companies need working capital to run its day-to-day activities. There is no business that does not need working capital. In order to reach its financial goals, however, different companies need different amounts of working capital. 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.
To understand about operating cycle better, let us see the main phases of an operating cycle. 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.
For an operating cycle, sales are the most important part because the time duration of sales determines the operating cycle. Credit sales of assets create accounts receivable.
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.
Key features of an Operating Cycle
In simple words, the operating cycle of a product is the time taken by it to get sold and generate cash right from the acquisition of the raw materials to finished goods.
Following are the key features of an Operating Cycle −
Conversion of Sales to Cash
It is also notable that almost all businesses aim to maximize the shareholders’ wealth and to do so it needs to earn enough profits. To earn a steady amount of profit, a company must be successful in carrying out a smooth and successful sales activity. To generate sales, a company needs to invest enough funds in its current assets. Current assets are important because sales do not convert into cash instantaneously. It takes time for the companies to realize the sales in terms of cash. Therefore, there is always an operating cycle associated with sales being converted to cash.
Liquidity Difference Between Fixed and Current Assets
There is a key difference between fixed and current assets in terms of liquidity. Current assets are more liquid than fixed assets. While fixed assets, such as plants and machinery and lands and buildings take many years to convert into sales, current assets can be converted into sales within a year’s operating cycle. In other words, while investments in fixed assets take enough time to realize, investments in current assets, such as inventory and wages are realized much earlier within the operating cycle.
Current assets are considered to be the sales force behind the operating cycle as fixed assets take too much time to get converted into sales. Depending on the current assets and the time taken for the debtors to pay, the operating cycle can be short or long.
Creation of Debtors Due to Credit Sales
The creation of debtors due to credit sales is another important aspect related to the operating cycle. The manufacturers usually have to sell products on credit to meet demands and thrive in competition. Credit sale creates debtors who constitute an important share of the operating cycle. Depending on the debtors’ time to pay for the items, the operating cycle can get shortened or elongated.
In most cases, the operating cycle goes on for a year or less for a manufacturing company. It also depends on the kind of products and the demand for it in the market to determine the operating cycle of a manufacturing company.
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