Working Capital Management Operating cycle

13th May 2021 1 By indiafreenotes

The operating cycle is the average period of time required for a business to make an initial outlay of cash to produce goods, sell the goods, and receive cash from customers in exchange for the goods. This is useful for estimating the amount of working capital that a company will need in order to maintain or grow its business.

A company with an extremely short operating cycle requires less cash to maintain its operations, and so can still grow while selling at relatively small margins. Conversely, a business may have fat margins and yet still require additional financing to grow at even a modest pace, if its operating cycle is unusually long. If a company is a reseller, then the operating cycle does not include any time for production it is simply the date from the initial cash outlay to the date of cash receipt from the customer.

The following are all factors that influence the duration of the operating cycle:

  • The payment terms extended to the company by its suppliers. Longer payment terms shorten the operating cycle, since the company can delay paying out cash.
  • The order fulfillment policy, since a higher assumed initial fulfillment rate increases the amount of inventory on hand, which increases the operating cycle.
  • The credit policy and related payment terms, since looser credit equates to a longer interval before customers pay, which extends the operating cycle.

Thus, several management decisions (or negotiated issues with business partners) can impact the operating cycle of a business. Ideally, the cycle should be kept as short as possible, so that the cash requirements of the business are reduced.

Examining the operating cycle of a potential acquiree can be particularly useful, since doing so can reveal ways in which the acquirer can alter the operating cycle to reduce cash requirements, which may offset some or all of the cash outlay needed to buy the acquiree.

Cash operating cycle = Inventory days + Receivable’s days – Payable’s days

Reasons for Prolonged Operating Cycle:

The above said periods are ascertained as follows:

  • Raw Material Holding Period:

Average raw material Stock/ (Average consumption of raw material /365)

  • Work-In-Process Period:

(Average work-in0process)/ (Average cost of goods/365)

  • Finished Goods Holding Period:

Average finished goods stock/(Average cost of goods sold/365)

  • Receivables Collection Period:

Average receivables/(Average sales/365)

  • Creditors Payment Period:

Average creditors/(Average purchase of raw materials/365)

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.

Reduction of 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.

  • 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.

  • 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.

  • 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.

  • 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.

  • 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.

  • 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.