# Operating Cycle

When a business trades, it purchases goods, holds them as inventory, converts them to a product for sale and sells them on credit, and finally it collects the cash from the sale. The operating cycle in financial management describes the time it takes to complete this process in days.

The operating cycle definition is the time period it takes from inventory purchase until the receipt of cash.

 ← Purchased Sold → Received → Inventory period Accounts receivable period Operating cycle

## Operating Cycle Formula

Operating cycle = Inventory conversion period + Accounts receivable collection period

### Inventory Conversion Period

The inventory conversion period is the length of time from the purchase of inventory to the time the sales are made on credit.

Inventory conversion period = Inventory / Daily cost of sales

In this formula inventory is the average of the beginning and ending inventory.

### Accounts Receivable Collection Period

The accounts receivable collection period is the average number of days it takes to collect accounts receivable. This is sometimes referred to the days sales outstanding or DSO.

Accounts receivable collection period = Accounts receivable / Daily sales

In this formula accounts receivable is the average of the beginning and ending accounts receivable balances

## Operating Cycle Example

Suppose a business has the following information about sales, cost of sales, inventory and accounts receivable. The information can be used to calculate the operating cycle of the business.

Operating cycle
Account Amount
Annual sales 3,000
Annual cost of sales 1,260
Average inventory 230
Average accounts receivable 360

In this example the operating cycle is calculated as follows:

```Inventory conversion period = Inventory / (Cost of sales / 365)
Inventory conversion period = 230 / (1,260 / 365) = 67 days
Accounts receivable collection period = Accounts receivable / (Sales / 365)
Accounts receivable collection period = 360 / (3000 / 365) = 44 days
Operating cycle = 67 + 44 = 111 days
```

On average it takes 111 days from the purchase of the inventory until the collection of cash.

The longer the inventory period and the accounts receivable collection period the longer the operating cycle of the business.

A long operating cycle means cash is tied up in inventory and accounts receivable. A business should aim to have as short an operating cycle as possible by reducing inventory holding time (but not so far that inventory shortages appear), and by improving accounts receivable collections.

The operating cycle differs from the cash conversion cycle in that the operating cycle does not allow for the accounts payable payment period. The operating cycle measures the time difference between the purchase of inventory and the collection of cash unlike the cash conversion cycle which measures the time difference between the payment for inventory and the collection of cash.

Operating Cycle November 6th, 2016

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