The operating cycle is the process that an industrial company goes through, on average, from the purchase of raw materials to the collection of sales after production. In the case of a purely commercial organization, it ranges from the purchase of goods to the collection of the proceeds from sales. This is explained by Aaron Rodriguez, a business expert with many years of experience in the area.
In part, the operating cycle is provided by the days in which the company has the raw material. This is appended to the period of the production cycle and the additional time it takes to bring the product to market. This entire process includes the investment or gross primary capital, accounts receivable and inventories.
The longer it is, the more investment the company will have in accounts receivable and warehousing and, therefore, the less profitable the cycle will be. If this happens, more bank loans or some type of additional financing will be needed for the process to be successful.
Rodriguez points out that a balance has to be found. The cycle cannot be so short, since it is not possible to have little raw material, insufficient inventories and it is not recommended to abruptly accelerate the production processes. If this happens, the quality of the products or services would be reduced in exchange for time savings.
“Many people have always asked me; how does this whole process relate to the cash cycle? A large part of the operating cycle is financed by suppliers, those from whom the company buys raw materials or merchandise. They give you a few days of credit, for example. This whole process, minus the credit days given by the suppliers, determines the cash cycle,” says Rodriguez. “It is about the net to be financed, either with bank debts, bonds, equity that can be retained earnings, etc.”.
In addition, the longer the cash cycle, the more financing will be needed to comply with the entire operating process. It must be remembered that, in case the payment is not met and the time is extended longer than expected, the whole operation could fail.
It is also called conversion or cash flow. To calculate it correctly, it is necessary to add the indicators of days of inventory and days of accounts receivable. However, it is also essential to evaluate external variables such as purchasing and credit sales policies, working capital, type of merchandise, among others.
“Understanding and formulating the relationship between both concepts are important for different types of professionals. Those who work in financial areas, professionals in charge of business plans, or entrepreneurs need to effectively relate both processes,” Rodriguez asserts.
The length of a company’s operating cycle is the so-called average maturity period, like the average time elapsed from the time the company buys raw materials or goods until the customer is paid, through the production process (if any), storage and sale. The average maturation period is broken down into the average duration period for the procurement of raw materials, the average duration period for the production process, and the average duration period for the storage of finished products.
Rodriguez says that “the average maturation period will depend, therefore, on the time it takes to procure raw materials, the time stocks remain in the warehouse, the duration of the production process, the credit granted to customers, collection policies, and supplier payment policies.”
If the average economic maturity period is longer than necessary, the company will have to make a greater investment in current assets: in inventories and accounts, receivable management and the cycle will in principle be less profitable. In this case, the company will need more bank loans or other additional financings to successfully cover its working capital needs.
In case a company shortens the average economic maturity period, it must take care that there is a sufficient supply of raw materials or products and that there are no stock-outs so that drastic time savings in the production process are not recommended. In addition, the expected quality of the products may not be met.
Suppliers and creditors, by granting us a payment period, contribute to financing part of the needs required for the operating cycle to be carried out. The average maturity period is therefore shortened.
In other words, this period financed by suppliers is deducted from the average economic maturity period or average duration of the operating cycle and the average financial maturity period is obtained. The first takes into account when the expense (purchase of raw materials or goods) is incurred and the second when the payment is made.