Failure to manage working capital leads a firm into bankruptcy. Operating Cycle (OC) is a tool that helps firms avoid such trouble. Let us look at the computation of OC along with its inference rule.
Let us assume the following figures (amount in Rs crore) for Devangshi Saumya Ltd (DS) for its latest financial year: Current assets 600; trade receivables 200; inventories 300; cash and cash equivalent 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 a firm takes to get back the cash that has gone out due to its operations in a specific period. It is the sum of days receivables and days inventories. Lower the operating cycle of a firm, better is its working capital efficiency.
Days Receivables (DR)
Also known as Days Sales Outstanding (DSO) or Average Collection Period (ACP), it reflects the number of days taken by a firm’s customers in paying their dues. It is calculated by dividing the trade receivables by daily credit sales. We usually consider sales as credit sales unless we have clarity on the proportion of cash and credit sales.
Daily credit sales are computed by dividing sales revenue for the year by 365 days. For DS, daily credit sales is Rs 3.29 crore (sales for the year 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 indicates that DS is taking on average 61 days to collect its receivables. If the firm’s DSO was 70 days in the previous year, then the firm has improved its collection efficiency in the current year.
Days Inventories (DI)
It is otherwise known as Days Sales Inventories (DSI).It reflects the number of days of inventory storage by a firm. It is calculated by dividing the inventories by the daily cost of goods sold (CGS). Daily CGS is computed by dividing CGS for the year by 365 days. For DS, daily CGS is Rs 1.37 crore (CGS for the year Rs 500 crore divided by 365 days) and DSI is 219 days (Inventories of Rs 300 crore divided by daily CGS Rs 1.37 crore). This indicates that DS is storing inventories for 219 days. If the firm’s DSI was 170 days in the previous year, then the firm has become inefficient in inventory management in the current year.
The operating cycle for DS for its latest financial year is 280 days (sum of days receivables of 61 days and days inventories of 219 days). However, it was 240 days in the previous year for DS. Therefore, the firm has become inefficient in its operating cycle management.
The writer is associate professor of Finance at XLRI – Xavier School of Management, Jamshedpur