Operating Cycle Homework Help & Tutoring
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Operating Cycle
Working capital is also known as revolving capital and a circular path of conversion/reconversion
takes place. This revolution of cycle is called as the operating cycle. Let us consider
an example to better understand operating cycle. A person starts a business with
an initial investment. With credit extended by expense creditors, he starts production
process. Goods of varying levels of finish results, and thus called as work-in-progress.
Once complete processing is done, it is called as finished goods. Until these goods
are sold, they remain in stock. Sales may be for cash and/or credit basis. The business
person needs to wait a little to realize cash from credit customers. The realized
cash is used to pay creditors. But he needs to maintain cash balance for day-to-day
operations as well as for meeting sudden spurt in payment obligations accompanied
by sluggish cash collections from debtors. Thus a revolution or cycle from cash
to raw materials to Work-in-Progress, to finished goods, to debtors, and back to
cash takes place. This revolution is called as operating cycle.
Thus, we can say that the term operating cycle, otherwise called as cash cycle refers
to the length of time necessary to complete the following cycle of events:
- Conversion of cash into inventory
- Conversion of inventory into debtors
- Conversion of debtors into cash
Stage 1: Cash to Inventory – In this stage, cash first gets converted
into raw materials, then work-in-progress and then finished goods in a typical manufacturing
concern. As regards non-manufacturing concerns, when the goods are purchased, cash
gets converted into inventory.
Stage 2: Inventory to Debtors – The inventory thus produced or purchased, gets converted into debtors or receivables upon credit sales.
Stage 3: The debtors or accounts receivables get in turn converted back into cash when they make payment.
Stage 2: Inventory to Debtors – The inventory thus produced or purchased, gets converted into debtors or receivables upon credit sales.
Stage 3: The debtors or accounts receivables get in turn converted back into cash when they make payment.
Length of operating cycle: When raw materials remain in
store pending issue for production for a less duration, when raw materials gets
converted into WIP in a short duration, when finished goods remain in warehouse
pending for sales for a short duration only, and when cash realizations out of sales
are made quickly and finally when payment to creditors is made slowly, the operating
cycle would be smaller and consequently the working capital will also be reasonable.
Thus shorter duration of operating cycle indicates an efficient working capital
management.
Example:
Computation of length of operating cycle:
Calculate the operating cycle.
Solution:
Computation of length of operating cycle:
| Period covered | 1 year of 365 days | |||||||||
| Average credit period allowed by creditors | 16 days | |||||||||
| Average total of debtors outstanding | $480,000 | |||||||||
| Total consumption of raw materials per annum | $4,400,000 | |||||||||
| Total production cost per annum | $10,000,000 | |||||||||
| Total cost of sales | $10,500,000 | |||||||||
| Sales during the year | $16,000,000 | |||||||||
Value of stock maintained:
|
|
Calculate the operating cycle.
Solution:
| Age of Raw materials |
= $320,000 x 365 =
$4,400,000 |
27 days |
| Age of WIP |
= $350,000 x 365 =
$10,000,000 |
13 days |
| Age of finished goods |
= $260,000 x 365 =
$10,500,000 |
9 days |
| Age of debtors |
= $480,000 x 365 =
$16,000,000 |
11 days
60 days |
| Less: Age of creditors (given) | 16 days | |
| Length of Operating cycle | 44 days | |
Computation of Working capital need through Operating cycle
The length of operating cycle can be used to estimate total working capital required.
First, we have to calculate the number of operating cycles in the period under study,
normally a year.
Therefore, number of operating cycles = Number
of days in a year
Length of operating cycle in days
In the above example, the number of cycles per annum would be 365 / 44 = 8.3 times.
Amount of working capital = Total Operating cost
No. of Operating cycles
If the operating cost per annum is $10,500,000, the amount of working capital would thus come to $10,500,000 ÷ 8.3 = $1,265,060 per operating cycle. Hence the significance of operating cycle concept in the efficient management of working capital.
Length of operating cycle in days
In the above example, the number of cycles per annum would be 365 / 44 = 8.3 times.
Amount of working capital = Total Operating cost
No. of Operating cycles
If the operating cost per annum is $10,500,000, the amount of working capital would thus come to $10,500,000 ÷ 8.3 = $1,265,060 per operating cycle. Hence the significance of operating cycle concept in the efficient management of working capital.
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