Failure to manage working capital leads to a company’s demise. The Operating Cycle (OC) is a technique that assists businesses in avoiding such problems. Let’s have a look at the OC computation and its inference rule.
Illustration fictitious
Assume the following numbers (in Rs crore) for Devangshi Saumya Ltd (DS) for the most recent fiscal year: Current assets: 600; trade receivables: 200; inventories: 300; cash and cash equivalents: 50; other current assets: 50; current liabilities: 400; trade payables: 140; accrued expenses: 60; current portion of long-term debt: 100; short-term bank loan: 50; other current liabilities: 50; sales revenue: 1,200; cost of goods sold: 500
OPERATING CYCLE (OC)
It refers to the number of days it takes a company to recover the cash that has been expended as a result of its activities within a certain period. It is calculated as the sum of days receivables and days inventory. The shorter a company’s operational cycle, the more efficient its working capital.
DAYS RECEIVABLE (DR)
It is also known as Days Sales Outstanding (DSO) or Average Collection Period (ACP), and it represents the number of days it takes a company’s customers to pay their bills. It is computed by dividing trade receivables by credit sales daily. Unless we are certain of the percentage of cash and credit purchases, we typically assume sales to be credit.
Daily credit sales are calculated by dividing annual sales income by 365 days. Daily credit sales for DS are Rs 3.29 crore (annual sales of Rs 1,200 crore divided by 365 days) and DSO is 61 days (Trade receivable Rs 200 crore divided by daily sales Rs 3.29 crore). This means that DS takes an average of 61 days to recover its receivables. If the firm’s DSO was 70 days the prior year, the firm’s collection efficiency has increased in the current year.
DAYS INVENTORIES (DI)
Days Sales Inventories is another name for it (DSI). It denotes the number of days a company keeps inventory. It is determined by dividing inventory by the cost of items sold daily (CGS). CGS for the day is calculated by dividing CGS for the year by 365 days. The daily CGS for DS is Rs 1.37 crore (CGS for the year Rs 500 crore divided by 365 days) while the DSI is 219 days (Inventories of Rs 300 crore divided by daily CGS Rs 1.37 crore). This means that DS is keeping inventory for 219 days. If the prior year’s DSI was 170 days, the firm’s inventory management has grown inefficient in the current year.
For the most recent fiscal year, DS’s operational cycle was 280 days (sum of days receivables of 61 days and days inventories of 219 days). DS, on the other hand, had 240 days the previous year. As a result, the company’s operational cycle management has become inefficient.
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