Definition: An operating cycle is the amount of time a company spends between spending money operating activities and collecting money from the same operating activity. Operating cycle often focus on the purchase and sale of assets.
What Does Operating Cycle Mean?
GAAP requires that assets and liabilities must be broken out into current and non-current categories on a balance sheet. This allows the financial statement user to see what assets will be used and what liabilities will come due in the current year or current operating cycle.
For instance a retailer’s operating cycle would be the time between buying merchandise inventory and selling the same inventory. A manufacturer’s operating cycle might start when the company spends money on raw manufacturing materials to make a product. The operating cycle wouldn’t end until the products are produced and sold to retailers or wholesalers.
Most companies try to keep their operating cycles at a year or less. This means that it would take a retailer an entire year to sell its inventory. Depending on the industry, this kind of an inventory turn might be unacceptable. Operating cycles are important because they determine cash flow. If a company is able to keep a short operating cycle, its cash flow will consistent and the company won’t have problems paying current liabilities.
Conversely, long operating cycle means that current assets are not being turned into cash very quickly. In other words, cash is not being collected from customer very quickly. Companies with longer operating cycles often have to borrow from banks in order to pay short term liabilities. These companies are often less profitable because of these extra loans.