Operating Cycle

What does it mean

The term Operating Cycle is meant to capture the journey a dollar of capital travels through a business. An example of an Operating Cycle begins with a dollar of capital. That dollar is then used to purchase a dollar of Raw Material Inventory. The business begins transforming the raw material in to the ultimate finished goods it will sell, but first it will become Work In Process before becoming a Finished Goods. The finished good is then sold to a customer of the business, and that sale results in the creation of an Accounts Receivable. This accounts receivable is then collected in the form of cash to then be used to begin the cycle again.  When this cash is collected, if the business has a positive gross profit margin, the business should collect more than the initial dollar that began the cycle. This additional margin can then be used to pay for other things such as Overhead Expenses, Debt Payments and Profit. 

Why does it matter

The Operating Cycle is the basis of how the business adds value and generates a profit.  Without an Operating Cycle, there is no business. By understanding the Operating Cycle, you can identify potential risks, industry norms and opportunities in a relationship. 

To give an example of how knowing an Operating Cycle can help to identify potential risks in a business, we will have a pretend coffee roasting business. In this coffee roasting business, the initial dollar is invested into unroasted green coffee (raw material) as well as other inventory type items (bags, labels, etc). Then after the coffee is roasted, but is not yet fully available for resale, that dollar is in the form of Work in Process. From there once packaging is completed, it becomes Finished Goods. These finished goods are sold to a grocery store and an Accounts Receivable is created. Eventually the Accounts Receivable is collected, and (if the business has a positive gross profit margin) the initial investment is recouped plus profit, and this profit can then be used to cover other items such as Overhead/Profit/Debt Obligations. 

By thinking through this Operating Cycle, potential risks can be identified:

1. Inventory Risk
1. Supplier Concentration?
2. Perishable Inventory?
3. Over/Under Investment in Inventory
2. Collections Risk
1. Average Days Receivable Outstanding
2. Typical Credit Terms relative to Industry Norms
3. Customer Concentrations

Other Relevant Terms

• Balance Sheet
• Income Statement
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