Accounting Operating Cycle Definition - Formula - Example - Importance

Accounting Operating Cycle simply defines as How many days a company takes to convert inventory or stock into cash. It indicates that how efficient the company is to generate cash from the selling of Inventory and, ultimately, the company makes prompt payment to Creditors. Operating Cycle is also know as Cash Operating Cycle or Cash Conversion Cycle, because it shows how many days the company converts inventory or stock into cash and also it determines the Working Capital Management of the business that is related to the management of smooth working flow of the business.

  

  Operating Cycle Formula: 

  

Inventor/ Stock Conversion Period + Account Receivable / Debtors Collection Period 

  

Here: 

  Inventory / Stock Conversion Period = Average Inventor or Stock / Cost of Sales / 365 

  

And 

Account Receivable / Debtors Collection Period = Average Account Receivable or Debtors / Sales / 365 

 

Note: To Convert Year Into Days we divide Average Inventory And Average Account Receivable By 365 respectively. 

  

By Getting the value of Inventory Conversion Period And Account Receivable, we can calculate Accounting Operating Cycle. 

  

Example: 

Suppose, A Company has Sales Rs. 5000, Cost of Sales Rs. 2000, Closing Inventory For the years is Rs. 2000 And Opening Inventory From the Previous Year is Rs. 3000, so Average Inventory is Rs. 2000 + 3000 / 2 = Rs. 2500. Closing Account Receivable is Rs. 1000 and Closing Account Receivable is Rs. 1500, so Average Closing Account Receivable = 1000 + 1500 / 2 = Rs. 1250.

  

Now To Calculate Accounting Operating Cycle: 

  

We, firstly, need to calculate Inventory Conversion Period and Then Debtor or Account Receivable Conversion Period. 

  

So, 

  

Inventory Conversion Period = 2500 / 365 = 7 days 

  

Account Receivable Conversion Period = 1250 / 365 = 3 Days 

  

By Putting The Values in Formula of Account Operating Cycle, we get: 

  

 7 + 3 = 10 

  

So, the company takes 10 days to convert Inventory or Stock into Cash. 

  

The shorter the Operating Cycle, the higher the ability of the company to make prompt payment to its creditors and its daily expenses. It also means that the Working Capital of the the company is good. 

  

If the Operating Cycle is good, then investors are encouraging to invest in that company as this company can easily generate profits and give return to investors in the specified period of time. 

  

You may also be interested in Types of Financial Ratios And Their Formulas

Importance of Operating Cycle 

  

It is very important for the working conditions of the business as the more quickly a company converts its inventory or stock into cash, the more easily it generate cash from the sales of inventory or stock and ultimately meet Current liabilities. 

  

So, we can say that Accounting Operating Cycle or Cash Operating Cycle shows the efficiency of company in converting the Inventory or Stock into Cash and ultimately helps in meeting daily expenses of the business in time that is essential for the smooth running of the Business and building the confidence of investors and Creditors with the company.