What is an Operating Cycle and Who does it Affect?
In essence, an operating cycle is the length of time that elapses between the moment a company buys a product as inventory, and the time the company sells that same product and turns it into income. This cycle is one of the most important factors when it comes to keeping businesses afloat.
Calculating the OC
The operating cycle of a business is calculated with a simple formula. The days payable outstanding is subtracted from the days inventory outstanding plus days sales outstanding to produce the average number of days it takes a company to turn cash spent into cash earned. In short, DPO - DIO + DSO = OC. Sound like jargon? In order to understand this equation, we must first be able to understand and calculate the figures for the terms used in the previous sentence.
Days Payable Outstanding
The days payable outstanding essentially amounts to the average number of days it takes a company to pay their suppliers. This is calculated using an efficiency formula which reads DPO = accounts payable balance divided by the total cost of goods sold per year divided by 365 days. So if a company has 2,500.00 in accounts payable, and 12,500.00 in total cost of goods sold, the DPO will equal (2,500/12,500) x 365 = 75 days. The higher this ratio is, the better the credit line a company receives from its suppliers will be, as they will reward the company for timely payment.
Days Inventory Outstanding
The days inventory outstanding is another efficiency calculation designed to determine how many days it takes for a company to turn its inventory into sales, or how long the average product is in a store before it sells. The days inventory outstanding is calculated like so: DIO = the average inventory divided by the total cost of goods sold per year times 365 days, similarly to the days payable outstanding. So using the same example as before: (2,500/12,500) x 365 = 37 days. In general the lower this number is, the better a company is doing financially.
Days Sales Outstanding
The days sales outstanding is a third ration which calculates the average age of accounts receivable. It is calculated by dividing the average accounts receivables of a company by its total sales times the number of days per year, or 365. So DSO = (100,000/1,000,000) x 365 = 36.5 days. This formula is used as a tool to measure and motivate employee performance, as it reflects the efficiency of a company’s operating systems and its ability to collect on debts owed by others.
The operating cycle is a calculation based on the three previously mentioned efficiency formulas. Using the examples above, our imaginary company has a DPO of 75, a DIO of 37, and a DSO of 36.5. Using the operating cycle formula, we can plug in these numbers to get a result of 75 – 37 + 36.5 = 74.5. Following this calculation, we thus determine that it takes this company approximately 74.5 days to turn the cash first spent on inventory into cash received as income.
The operating cycle is a useful tool for calculating company profitability. Though the ratios may seem daunting, there is no need for alarm – if you passed third grade math, you can handle this too!