So this is our first post in a series titled Sycamore Business Lab (SBL). The aim of these posts is to help educate small businesses and individuals on basic business concepts in a simple but practical way. In this first post, we will be looking at the Operating Cycle. Please let us know what you think. Enjoy!
Have you ever found yourself wondering why some businesses seem to be facing financial issues and why some are even forced out of business entirely due to not being able to meet up with expenses?
Or have you ever witnessed a rapidly growing business — offering excellent products and services — suddenly in dire need of external finance to avoid shutting down and closing shop?
If you answered yes to any of these questions and would like to learn some of the common causes of this scenario then you have come to the right place. This article highlights one of the key things that businesses must keep an eye on to better manage their cash and ultimately survive — the operating cycle.
What is an Operating Cycle?
An Operating Cycle (OC) refers to the number of days required for a business to receive inventory, sell the inventory, and collect cash from the sale of the inventory. In other words, it indicates how many days it takes between spending cash on buying goods and collecting cash from selling them. The number of days can be calculated using the following formula:
Or if you are not into formulas, you can use the simple diagram below:
Importance of the Operating Cycle
The operating cycle can be used as an indicator to assess a business’s efficiency. Generally speaking, having a lower cycle is preferred because it indicates a successful, operationally efficient business that is able to meet its day-to-day financial obligations as they might arise.
However, it is important to note that some businesses are typically better than others at keeping a low operating cycle due to the nature of the business and market practices. For instance, in some cases, it is important to offer credit sales to your customers or they will not buy. We mostly see these sorts of practices when a business is selling products or services to other businesses (B2B). Whatever the case might be, the best thing to do if possible is to try to find comparable companies and measure how your business performs side by side.
How to improve a businesses Operating Cycle
As mentioned above, there are two things to consider when thinking about a business’s operating cycle, the number of days inventory is sitting around and the number of days it takes to collect cash from customers. Therefore, there are two possible ways to improve your operating cycle, which are as follows:
1. Improve your inventory management
The quicker a business is able to sell its inventory the more it is able to reduce its operating cycle days. Additionally, one could consider whether it is possible to adopt a just-in-time inventory management strategy, where inventory is an order for each request and spends only enough time in your business to timely deliver on an order.
2. Improve your collection management
The more a business is able to improve the collection of it receivable from its customers the more the operating cycle days will reduce and improve the cash flow within the business. Again, one must consider the market in which they are playing and discover how other players in the market are faring. This is because if you become too strict with your sales policy, customers might decide to take their business elsewhere for more favourable terms.