Failure to handle working capital leads a firm into bankruptcy. Operating Cycle (OC) is a tool that assists firms prevent such problems. Let us look at the computation of OC along with its inference rule.
Hypothetical illustration
Let us assume the following figures (quantity in Rs crore) for Devangshi Saumya Ltd (DS) for its most recent economic year: Current assets 600 trade receivables 200 inventories 300 money and money equivalent 50 other present assets 50 present liabilities 400 trade payables 140 accrued expenditures 60 present portion of extended term debt one hundred brief term bank loan 50 other present liabilities 50 sales income 1,200 price of goods sold 500.
Operating Cycle (OC)
It refers to the quantity of days a firm requires to get back the money that has gone out due to its operations in a certain period. It is the sum of days receivables and days inventories. Lower the operating cycle of a firm, much better is its working capital efficiency.
Days Receivables (DR)
Also recognized as Days Sales Outstanding (DSO) or Average Collection Period (ACP), it reflects the quantity of days taken by a firm’s shoppers in paying their dues. It is calculated by dividing the trade receivables by every day credit sales. We normally contemplate sales as credit sales unless we have clarity on the proportion of money and credit sales.
Daily credit sales are computed by dividing sales income for the year by 365 days. For DS, every day 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 every day sales Rs 3.29 crore). This indicates that DS is taking on typical 61 days to gather its receivables. If the firm’s DSO was 70 days in the preceding year, then the firm has enhanced its collection efficiency in the present year.
Days Inventories (DI)
It is otherwise recognized as Days Sales Inventories (DSI).It reflects the quantity of days of inventory storage by a firm. It is calculated by dividing the inventories by the every day price of goods sold (CGS). Daily CGS is computed by dividing CGS for the year by 365 days. For DS, every day 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 every day 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 preceding year, then the firm has come to be inefficient in inventory management in the present year.
The operating cycle for DS for its most recent economic year is 280 days (sum of days receivables of 61 days and days inventories of 219 days). However, it was 240 days in the preceding year for DS. Therefore, the firm has come to be inefficient in its operating cycle management.
The writer is associate professor of Finance at XLRI – Xavier School of Management, Jamshedpur