THE OPERATING CYCLE AND WORKING CAPITAL NEEDS

The working capital requirement of a firm depends, to a great extent upon the operating cycle of the firm.  The operating cycle may be defined as the time duration starting from the procurement of goods or raw materials and ending with the sales realization.  The length and nature of the operating cycle may differ from one firm to another depending upon the size and nature of the firm.

In a trading concern, there is a series of activities starting from procurement of goods (saleable goods) and ending with the realization of sales revenue (at the time of sale itself in case of cash sales and at the time of debtors realizations in case of credit sales).  Similarly, in case of manufacturing concern, this series starts from procurement of raw materials and ending with the sales realization of finished goods (after going through the different stages of production).  In both the cases, however, there is a time gap between the happening of the first event and the happening of the last event.  This time gap is called the operating cycle.

Thus, the operating cycle of a firm consists of the time required for the completion of the chronological sequence of some or all of the following:

i)    Procurement of raw materials and services.
ii)    Conversion of raw materials into work-in-progress.
iii)    Conversion of work-in-progress into finished goods.
iv)    Sale of finished goods (cash or credit).
v)    Conversion of receivables into cash.

These activities create and necessitate cash flows which are neither synchronized nor certain.  The relevant cash flows are not synchronized because the cash disbursements (i.e., payment for purchases) take place before the cash inflows (from sales realizations).  These cash flows are uncertain because these depend upon the future costs and sales.  Of course, the cash outflows relating to payment for purchases and payment for wages and other expenses are less uncertain with respect to time as well as quantum.  What is required on the part of a firm is to make adjustments and arrangements so that the uncertainty and unsynchronization of these cash flows can be taken care of.  The firm is often required to extend credit facilities to customers.  The finished goods must be kept in store to take care of the orders and a minimum cash balance must be maintained.  It must also have a minimum of raw materials to have smooth and uninterrupted production process.  So, in order to have a proper and smooth running of the business activities, the firm must make investments in all these current assets.  This requirement of funds depends upon the operating cycle period of the firm and is also denoted as the working capital needs of the firm.

Operating Cycle Period:  The length or time duration of the operating cycle of any firm can be defined as the sum of its inventory conversion period and the receivable conversion period.
 
i)    Inventory Conversion Period (ICP):  It is the time required for the conversion of raw materials into finished goods sales.  In a manufacturing firm the ICP is consisting of Raw Material Conversion Period (RMCP), Work-in-progress Conversion Period (WPCP), and the Finished Goods Conversion Period (FGCP).  RMCP refers to the period for which the raw material is generally kept in stores before it is issued to the production department.  The WPCP refers to the period for which the raw material remains in the production process before it is taken out as a finished unit.  The FGCP refers to the period for which finished units remain in stores before being sold to a customer.

ii)    Receivables Conversion Period (RCP):  It is the time required to convert the credit sales into cash realization.  It refers to the period between the occurance of credit sales and collection from debtors.

The total of ICP and RCP is also known as Total Operating Cycle Period (TOCP).  The firm might be getting some credit facilities from the supplier of raw materials, wage earners etc.  This period for which the payments to these parties are deferred or delayed is known as Deferral Period (DP).  The Net Operating Cycle (NOC) of the firm is arrived at by deducting the DP from the TOCP.  Thus,

NOC        =    TOCP-DP
                 =    ICP+RCP-DP

For calculation of TOCP and NOC, various conversion periods may be calculated as follows:

RMCP        =         Average Raw material stock          x  365
                              Total Raw material consumption

WPCP        =         Average Work-in-progress    x  365
                                Total Cost of production

FGCP        =         Average Finished Goods     x  365
                              Total Cost of goods sold

RCP          =         Average Receivable       x  365
                              Total Credit sales

DP             =         Average Creditors          x  365
                              Total Credit purchase


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