An operating cycle is the period of time from the moment raw materials are purchased to when cash is received from customers. This financial ratio measures the performance of working capital management. An increase in the duration of the operating cycle results in more working capital needed. Conversely, a decline of this ratio indicates less working capital needed.
The formula for determining the operating cycle in days is expressed as follows:
In turn, the days of sales in inventory (DSI) is calculated as follows:
where Average Inventory is the average balance of the Inventory Account during an accounting period, COGS is the cost of goods sold, and T is the number of days in the accounting period (e.g., if a business prepares financial statements annually, T=365).
The formula for days of sales outstanding (DSO) is as follows:
where Average Accounts Receivable is the average balance in Accounts Receivable during an accounting period.
The deeper decomposition of the operating cycle is shown in the figure below.
As we can see, days of sales in inventory can be broken down into three components:
- Raw materials holding period
- Work in progress period
- Finished goods holding period
We can also calculate them as follows:
Duration of operating cycle
The duration of the operating cycle is given in the figure below.
- A is when raw materials enter the stock
- B is when raw materials leave the stock and production starts
- C is when production ends and finished goods enter the stock
- D is when finished goods are sold and the credit period starts
- E is when a business receives payment for delivered goods
Please note! If the credit policy of a business prohibits any sales of goods on credit, the duration of the operating cycle is equal to the duration of the production cycle or days of sales in inventory.
Information about inventory and accounts receivable of Total SAR in 20X8 financial year is as follows:
The revenue of Total SAR in 20X8 financial year is $5,475,000. All sales were made on credit. The cost of goods sold is $3,285,000 for the same period.
We have to calculate the days of sales in inventory and days of sales outstanding to find the duration of the operating cycle. Let’s put the data available in the formulas mentioned above.
Average Inventory = ($580,000 + $500,000) / 2 = $540,000
Average Accounts Receivable = ($730,000 + $770,000) / 2 = $750,000
DSI = $540,000 / $3,285,000 × 365 = 60 days
DSO = $750,000 / $5,475,000 × 365 = 50 days
Thus, the duration of the operating cycle of Total SAR is 110 days.
We can also break down the production cycle of Total SAR.
Average Raw Materials = ($130,000 +$140,000) / 2 = $135,000
Average Work in Progress = ($240,000 + $210,000) / 2 = $225,000
Average Finished Goods = ($210,000 + $150,000) / 2 = $180,000
Raw Materials Holding Period = $135,000 / $3,285,000 × 365 = 15 days
Work in Progress Period = $225,000 / $3,285,000 × 365 = 25 days
Finished Goods Holding Period = $180,000 / $3,285,000 × 365 = 20 days
These calculations confirm that the production cycle of Total SAR is 60 days (15+25+20).