The operating cycle of a business
/What is the Operating Cycle?
The operating cycle is the average period of time required for a business to make an initial outlay of cash to produce goods, sell the goods, and receive cash from customers in exchange for the goods. This is useful for estimating the amount of working capital that a company will need in order to maintain or grow its business.
A company with an extremely short operating cycle requires less cash to maintain its operations, and so can still grow while selling at relatively small margins. Conversely, a business may have fat margins and yet still require additional financing to grow at even a modest pace, if its operating cycle is unusually long. If a company is a reseller, then the operating cycle does not include any time for production - it is simply the date from the initial cash outlay to the date of cash receipt from the customer.
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Factors Impacting the Operating Cycle
The following are all factors that influence the duration of the operating cycle:
The payment terms extended to the company by its suppliers. Longer payment terms shorten the operating cycle, since the company can delay paying out cash. It can make sense to consolidate purchases with those suppliers who offer longer payment terms.
The order fulfillment policy, since a higher assumed initial fulfillment rate increases the amount of inventory on hand, which increases the operating cycle.
The credit policy and related payment terms, since looser credit equates to a longer interval before customers pay, which extends the operating cycle. It can be useful to offer an early payment discount, if doing so will yield a dramatic decline in the amount of receivables outstanding. In addition, consider eliminating those suppliers who abuse the company’s payment terms, and especially those who are at high risk of not paying at all.
The efficiency of internal processes. Processes with many steps and wait times can dramatically lengthen the time needed to fulfill customer orders. This time can be reduced by eliminating non-value-added steps, as well as by using technology to streamline or completely automate processes.
Thus, several management decisions (or negotiated issues with business partners) can impact the operating cycle of a business. Ideally, the cycle should be kept as short as possible, so that the cash requirements of the business are reduced.
Operating Cycle Best Practices
Examining the operating cycle of a potential acquiree can be particularly useful, since doing so can reveal ways in which the acquirer can alter the operating cycle to reduce cash requirements, which may offset some or all of the cash outlay needed to buy the acquiree.
Another best practice is to review all planned product introductions in terms of their associated operating cycles. For example, if a planned new product requires expensive component purchases from a supplier that demands cash-on-delivery payments, this will greatly increase the working capital requirements for the product, and might even lead to a decision not to sell the product.
Terms Similar to the Operating Cycle
The operating cycle is also known as the cash-to-cash cycle, the net operating cycle, and the cash conversion cycle.