Operating cycle is the time required to purchase the goods, sell the goods & collect payments from customers. It is an efficiency ratio and can do wonders if corrective actions are taken to improve this ratio. Short operating cycle is considered as the good one because company is recovering the cash tied up in the purchasing & selling the product early.
Formula
Operating cycle = (Average inventories / purchases) x 365 + (Average accounts receivable / Credit sales) x 365
Or, it can be written as:
= Days sales outstanding + Day’s sales of inventory
Example
Inventory 1 Jan 2014 = $21,000,
Inventory 1 Jan 2015 = $20,000
Purchases = $150,000
Credit Sales = $230,000
Average accounts receivable = $6,000
Required: Calculate the operating cycle of alpha industries.
Solution
Average inventories = (Opening balance inventories + Closing balance inventories) / 2 = (21,000 + 20,000) / 2 = $20,500
Using the operating formula, we can input the field as:
Operating cycle = (20,500/150,000) x 365 + (6,000 / 230,000) x 365 = 49.88 + 9.52 = 59.4 days