Operating Cycle

Understand the Operating Cycle Concept

• What is the definition of the operating cycle?
• What does the operating cycle measure?
• What formula calculates the operating cycle?
• Is a higher or lower operating cycle preferable?

Operating Cycle Formula

Conceptually, the operating cycle measures the time it takes a company on average to purchase inventory, sell the finished inventory, and collect cash from customers that paid on credit.

• Start of Operating Cycle: The “start” of the cycle refers to the date when the inventory (i.e. raw material) was purchased by the company to turn it into a marketable product available for sale.
• End of Operating Cycle: The”end” is when cash payment for the product purchase is received from customers, who often pay on credit as opposed to cash (i.e. accounts receivable).

Days Inventory Outstanding + Days Sales Outstanding

The operating cycle formula consists of two working capital metrics:

DIO and DSO Formula

Below are the formulas for calculating the two working capital metrics:

• DIO = (Average Inventory / Cost of Goods Sold) * 365 Days
• DSO = (Average Accounts Receivable / Revenue) * 365 Days

The DIO and DSO of a company are the two required inputs in the operating cycle formula, which is shown below.

Operating Cycle Formula

• Operating Cycle = DIO + DSO

The calculation of the operating cycle is relatively straightforward, but more insights can be derived from examining the drivers behind DIO and DSO.

For instance, the operating cycle of a company could be high relative to that of comparable peers.

Such an issue could stem from the inefficient collection of credit purchases, rather than being due to supply chain or inventory turnover issues.

Once the real issue has been identified, management can better address and fix the problem.

Interpreting the Operating Cycle

The lower the operating cycle, the more efficient the company’s operations are – all else being equal.

On the other hand, higher operating cycles point towards weaknesses in the business model that must be addressed.

The longer the operating cycle, the more cash is tied up in operations (i.e. working capital needs), which directly lowers a company’s free cash flow (FCF).

Operating Cycle vs Cash Conversion Cycle

The cash conversion cycle (CCC) measures the number of days for a company to clear out its inventory in storage, collect outstanding A/R in cash, and delay payments (i.e. accounts payable) owed to suppliers for goods/services already received.

Cash Conversion Cycle Formula

• Cash Conversion Cycle (CCC) = Days Inventory Outstanding (DIO) + Days Sales Outstanding (DSO) – Days Payable Outstanding (DPO)

The start of the calculation, adding DIO and DSO, represents the operating cycle – and the added step is subtracting DPO.

Hence, the cash conversion cycle is used interchangeably with the term “net operating cycle”.

Operating Cycle Excel Template

Let’s move on to a modeling exercise to practice calculating the operating cycle.

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Operating Cycle Example Calculation

In our illustrative example, we will calculate the operating cycle of a company with the following assumptions:

Model Assumptions

Year 1 Financials

• Revenue: \$100 million
• Cost of Goods (COGS): \$60 million
• Inventory: \$20 million
• Accounts Receivable (A/R): \$15 million

Year 2 Financials

• Revenue: \$120 million
• Cost of Goods (COGS): \$85 million
• Inventory: \$25 million
• Accounts Receivable (A/R): \$20 million

The first step is to calculate DIO by dividing the average inventory balance by the current period COGS and then multiplying it by 365.

• DIO = AVERAGE (\$20m, \$25m) / \$85 * 365 Days
• DIO = 97 Days

On average, it takes the company 97 days to purchase raw material, turn the inventory into marketable products, and sell it to customers.

In the next step, we will calculate DSO by dividing the average A/R balance by the current period revenue and multiplying it by 365.

• DSO = AVERAGE (\$15m, \$20m) / \$120m * 365 Days
• DSO = 53 Days

The operating cycle is equal to the sum of DIO and DSO, which comes out to 150 days in our modeling exercise.

• Operating Cycle = 97 Days + 53 Days = 150 Days