In this article we will discuss about operating cycle and its functions.
Working capital is the life blood of any business, without which the fixed assets are inoperative. Working capital circulates in the business, and the current assets change from one form to the other. Cash is used for procurement of raw materials and stores items and for payment of operating expenses, then converted into work-in-progress, then to finished goods.
When the finished goods are sold on credit terms receivables balances will be formed. When the receivables are collected, it is again converted into cash. The need for working capital arises because of time gap between production of goods and their actual realization after sales. This time gap is called technically called as ‘operating cycle’ or ‘working capital cycle’.
The operating cycle of a company consists of time period between the procurement of inventory and the collection of cash from receivables. The operating cycle is the length of time between the company’s outlay on raw materials, wages and other expenses and inflow of cash from sale of goods. Operating cycle is an important concept in management of cash and management of working capital.
The operating cycle reveals the time that elapses between outlay of cash and inflow of cash. Quicker the operating cycle less amount of investment in working capital is needed and it improves the profitability. The duration of the operating cycle depends on the nature of industry and the efficiency in working capital management.
The above said periods are ascertained as follows:
(a) Raw Material Holding Period:
(b) Work-In-Process Period:
(c) Finished Goods Holding Period:
(d) Receivables Collection Period:
(e) Creditors Payment Period:
The knowledge of operating cycle is essential for smooth running of the business without shortage of working capital. The working capital requirement can be estimated with the help of duration of operating cycle. The longer the operating cycle, the larger the working capital requirements. If depreciation is excluded from expenses in the operating cycle, the net operating cycle represents ‘cash conversion cycle’.
The length of operating cycle is the indicator of efficiency in management of short-term funds and working capital. The operating cycle calls for proper monitoring of external environment of the business. Changes in government policies like taxation, import restrictions, credit policy of central bank etc. will have impact on the length of operating cycle.
It is the task of Finance manager to manage the operating cycle effectively and efficiently. Based on the length of operating cycle, the working capital finance is done by the commercial banks. The reduction in operating cycle will improve the cash conversion cycle and ultimately improve the profitability of the firm.
Reasons for Prolonged Operating Cycle:
The following could be the reasons for longer operating cycle period:
(a) Purchase of materials in excess/short of requirements.
(b) Buying inferior, defective materials.
(c) Failure to get trade discount, cash discount.
(d) Inability to purchase during seasons.
(e) Defective inventory policy.
(f) Use of protracted manufacturing cycle.
(g) Lack of production planning, coordination and control.
(h) Mismatch between production policy and demand.
(i) Use of outdated machinery, technology,
(j) Poor maintenance and upkeep of plant, equipment and infrastructure facilities,
(k) Defective credit policy and slack collection policy.
(l) Inability to get credit from suppliers, employees,
(m) Lack of proper monitoring of external environment etc.
How to Reduce Operating Cycle?
The aim of every management should be to reduce the length of operating cycle or the number of operating cycles in a year, only then the need for working capital decreases. The following remedies may be used in contrasting the length of operation cycle period.
i. Purchase Management:
The purchase manager owes a responsibility in ensuring availability of right type of materials in right quantity of right quality at right price on right time and at right place. These six R’s contribute greatly in the improvement of length of operating cycle. Further, streamlining of credit from supplier and inventory policy also help the management.
ii. Production Management:
The Production manager affects the length of operating cycle by managing and controlling manufacturing cycle, which is a part of operating cycle and influences directly. Longer the manufacturing cycle, longer will be the operating cycle and higher will be the firm’s working capital requirements.
The following measures may be taken like:
(a) Proper maintenance of plant, machinery and other infrastructure facilities,
(b) Proper planning and coordination at all levels of activity,
(c) Up-gradation of manufacturing system, technology, and
(d) Selection of the shortest manufacturing cycle out of various alternatives etc.
iii. Marketing Management:
The sale and production policies should be synchronized as far as possible. Lack of matching increases the operating cycle period. Production of qualitative products at lower costs enhances sales of the firm and reduces finished goods storage period. Effective advertisement, sales promotion activities, efficient salesmanship, use of appropriate distribution channel etc., reduce the storage period of the finished products.
iv. Credit Collection Policies:
Sound credit and collection policies enable the Finance manager in minimizing investment in working capital in the form of book debts. The firm should be discretionary in granting credit terms to its customers.
In order to see that the receivable conversion period is not increased, the firm should follow a rationalized credit policy based on the credit standing of customers and other relevant facts. The firm should be prompt in making collections. Slack collection policies will tie-up funds for long period, increasing length of operating cycle.
v. External Environment:
The length of operating cycle is equally influenced by external environment. Abrupt changes in basic conditions would affect the length of operating cycle. Fluctuations in demand, competitors, production and sales policies, government fiscal and monetary policies, changes on import and export front, price fluctuations, etc., should be evaluated carefully by the management to minimize their adverse impact on the length of operating cycle.
vi. Personnel Management:
The Personnel manager by framing sound recruitment, selection, training, placement, promotion, transfer, wages, incentives and appraisal policies can contrast the length of operating cycle.
Use of Human Resources Development technique in the organization enhances the morale and zeal of employees thereby reduces the length of operating cycle. Proper maintenance of plant, machinery, infrastructure facilities, timely replacement, renewals, overhauling etc., will contribute towards the control of operating cycle.
These measures, if adhered properly, would go a long way in minimizing not only the length of operating cycle period but also the firm’s working capital requirements.