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. This 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 to maintain its operations, 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. 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 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. Ideally, the cycle should be kept as short as possible, so that the cash requirements of the business are reduced.
Examining the operating cycle of a potential acquiree can be particularly useful, since doing so can reveal ways in which the acquirer can alter the operating cycle to reduce cash requirements, which may offset some or all of the cash outlay needed to buy the acquiree.