In a business, operating cycle is the length of time a company takes starting from the time when cash is invested in goods and services to the time that investment produces cash. This means in a business, it comprises three phases:
- Purchase raw materials in cash or credit and produce goods.
- Sell goods for cash or in credit.
- Collect cash from credit sales, settle short-term obligations and generate cash.
Company uses cash to purchase raw materials, hire workers, incur expenses; with these inputs, it makes finished products and keep it temporarily in inventory. If the company sells these finished products for cash, the physical inventory changes back into cash immediately. If the sale is on credit, cash is realized when customers pay for the goods sold. During the entire period of credit, credit sale is shown as accounts receivable in balance sheet. This movement of cash to inventory, inventory to accounts receivable, and back to cash is known as operating cycle or working capital cycle of a company. Operating cycle is considered as the lifeblood of a company.
To illustrate the process let us assume that a company is manufacturing product Z by following below process;
- Company uses cash to purchase inventory items required to manufacture the end product Z.
- It takes 90 days to manufacture the finished product Z.
- Finished product Z is sold to customer with 30 days credit term.
- Company receives money back from customers 40 days after the sales occurred.
In this case, the operating cycle of the company is 130 days (i.e. 90+40). We can’t consider 30 days credit limit in the calculation as the actual credit period is 40 days.
Use of operating cycle for classification of assets
For balance sheet reporting, assets are generally classified to current and non-current based on the operating cycle period of the businesses. In some industries such as shipbuilding business, the period is always more than one year. If its more than a year, then classification should be changed accordingly by taking the time period as more than a year.
Any asset which is expected to be converted to cash,sold or consumed during the next 12 months or within the businesses operating cycle, if longer than a year, is known as current assets.
Similarly, if a debt is due to be paid within 12 months or within the businesses operating cycle (if its longer than a year), are classified as current liabilities. All other obligations to be settled beyond this period is treated as long-term liabilities.
To classify a particular asset and liability as current and non-current, management need to consider the time period as one year or within the operating cycle, whichever is longer. If a particular asset has no relationship with the operating cycle, then to classify it as current or non-current, management generally consider the net realizable period as one year.
Working capital is defined as the difference between current assets and current liabilities. To calculate working capital, you need to first calculate total current assets and total current liabilities and then in the second step, you have to deduct both get working capital. Working capital can be defined as the money that a company should have to run the operating cycle.
Longer operating cycle means, the company need more current assets as it takes for the inventories and accounts receivables to convert into cash. This means it needed greater amount of working capital.