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. 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.
The operating cycle 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, 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.
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.
- 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.
Thus, several management decisions (or negotiated issues with business partners) can impact the operating cycle of a business.
The operating cycle is also known as the cash-to-cash cycle, the net operating cycle, and the cash conversion cycle.