- paying for the raw materials needed in its products
- paying for the labor and overhead costs needed to convert the raw materials into products
- holding the finished products in inventory until they are sold
- waiting for the customers' cash payments for the products that have been sold
Some calculate the operating cycle to be the sum of:
- the days' sales in inventory (365 days/inventory turnover ratio), plus
- the average collection period (365 days/accounts receivable turnover ratio)
The above sum is sometimes reduced by the number of days in the credit terms of the accounts payable.
The operating cycle has importance in classifying current assets and current liabilities. While most manufacturers have operating cycles of several months, a few industries require very long processing times. This could result in an operating cycle that is longer than one year. To accommodate those industries, the accountants' definitions of current assets and current liabilities include the following phrase: ...within one year or within the operating cycle, whichever is longer.
To assist you in computing and understanding accounting ratios, we developed 24 forms that are available as part of AccountingCoach PRO.
You can also read our Explanation of Financial Ratios.