Operating Cycle Concept: Concept Determining Working Capital Requirement, In today’s world, the Operating cycle of Working capital is something that has acquired a huge importance and plays a vital role in decision-making by the organization in determining working capital needs. Must Check List of Ind AS.
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Concept Determining Working Capital Requirement
What is an OPERATING CYCLE?
The operating cycle in simple words is time required from POINT A to POINT B where point A is ACQUISITION OF RAW MATERIAL and point B is INITIAL CASH REALIZATION.
The operating cycle can be explained as follows
- An organization acquires Raw materials from various vendors. This raw material is not immediately consumed always and thus it involves the Raw material Conversion Period.
- Now the raw material is issued for production and WIP is produced. There is always a gap between the issue of material and the production of finished goods thus it involves WORK IN PROGRESS CONVERSION PERIOD
- Now from Work in progress finally finished goods are produced
- These finished goods are sold to different customers and a Current asset called debtors is recorded into the books of the organization. Every organization today faces heavy price competition and customers are smart enough to focus on Credit period policy thus we are required to give credit period to the customers for payment. This involves the BOOK DEBT CONVERSION PERIOD
- The operating cycle comes to an end when the current assets named debtors are converted into cash.
- We can determine the total period of the gross operating cycle using the below formula
GROSS OPERATING CYCLE = RMCP+WIPCP+FGCP+BDCP
- The above formula will tell you the exact number of days that are required to realize cash by selling finished goods.
Operating Cycle Period Should Be Low
We should always remember that the operating cycle should be kept as low as possible. If the operating cycle is long then we will not be able to meet Cash requirements and thus we have to fulfill working capital requirements by raising money from other sources. Organization for payment of Raw materials also gets some credit period this is known as the payment deferral period. It would be good if we could keep the payment deferral period higher than the Book Debt Conversion period. Must Check Limitations of Accounting.
How To Determine Working Capital Requirement With The Help Of Operating Cycle
The working capital requirement can be determined with the help of the formula mentioned below. However, COGS may be taken on some estimation basis
{Cost of Goods sold* operating cycle period/360}+Desired cash balance
Diagram Representing Operating Cycle Concept
As we have already discussed we should keep the operating cycle period as low as possible. Here are a few ways by which we can reduce the operating cycle period.
- Receiving appropriate Credit period for Raw material payment: The role of purchase manager today has changed a lot. Earlier purchase managers were to purchase raw materials based on quotations with the lowest price by ranking them as L1, L2, L3, L4, etc. However, in the present scenario, focus should also be given to the credit period allowed for payment. Thus purchase manager plays a vital role in reducing the operating cycle.
- MANAGING PRODUCTION: Suppose a product has to pass through three different processes to get converted into the finished product then this process should be performed such that the total time required for the process is minimum and the goods are produced within minimum time.
- MARKETING MANAGEMENT: There must be some relationship between production and sales. Matching between production and sales is very important for reducing the operating cycle. If we are going on producing goods having no demand in the market then we are only increasing finished goods stock and blocking much required working capital.
- CREDIT POLICY: We should be firm in deciding and forming a credit policy. Our policy should help us achieve our target sales and reduce the overall operating cycle. You may also like Accrued Liabilities.
