Operating and financial cycle: what they are, examples and calculation

One of the biggest nightmares for business owners — or freelancers in particular — is the efficient management of their finances. To achieve this, it will be necessary to master other types of company cycles, such as operational and financial cycles.

After all, they help you calculate the real economic situation of your business and, therefore, help you take the best decisions for improving your results. Since this is a subject on which the maintenance and growth of your company depend, we have prepared this complete post so that it answers all your questions.

Next, you will understand the concept of each of these two cycles and discover how to calculate them correctly, among other relevant points. Keep reading!

Why is it important to understand the operating and financial cycles?

To care for the financial health of the company is essential. It’s only when there is proper management of resources that a good stock can be maintained, and investments can be made in new solutions, measures to ensure profitability in the short, medium, and long terms.

However, many entrepreneurs fail to analyze their company’s financial situation and, therefore, cannot make a very sound decision. The big issue is that a wrong decision-or-a wrong time decision-is one of the most common causes of business failure.

To prevent this from happening, managers need to understand how to properly manage the operational cycle and the financial cycle. Both refer to your company’s need for financial resources. In other words, they are linked to the inflow and outflow of money.

It is important to note that both cycles take into account the average storage period, which often does not receive due attention from entrepreneurs. In addition, they are related to the liquidity and profitability of the enterprise, considering that:

• liquidity — the ease with which an asset can be turned into cash;
• profitability — refers to the analysis of results taking into account investments , costs, among other factors.

Thus, both are essential for analyzing the need for working capital , as well as for projecting cash flow. In practice, they become extremely important tools for decision-making, as mentioned, and for improving business results.

What is the operating cycle?

This is the sum total of all phases of a business operation. In simple words, the operating cycle begins with the purchase of raw materials, proceeds with payments to the suppliers, manufacturing of the product and sales, and comes to an end by receiving payment for the sale of the merchandise. This, in simple words, comprehends the whole time phase of inflow and outflow of cash.

For this reason, calculating the operating cycle is essential to determine the value of working capital and to more effectively control inventory. Another important point to be analyzed is that the shorter the operating cycle, the better, because it will be possible to quickly reach the payment stage.

To understand it more easily, it is interesting to think about agricultural activities . In this context, it begins when the producer buys the seeds and ends after the harvest, when he receives payment for the production. These are longer cycles, but with a fixed date due to the harvests.

On the other hand, industrial cycles are shorter. After all, raw materials are constantly arriving and production is constant. As a result, products are delivered more frequently.

So how to calculate it?

The formula for the operating cycle is not at all complex. Development involves the sum of the average time that raw materials and finished products are stored and the average time between sale and receipt. Therefore, it is simply organized as follows:

operating cycle = average storage period + average receipt period

Example: suppose the company’s average storage period is 20 days and an average receipt period is 64 days. The operating cycle will therefore be 84 days.

Therefore, it means that for the firm to buy the raw material, get it on the production line, manufacture the chairs, sell them, and receive payment will take 84 days.

What is the financial cycle?

It is the process of raising, managing, and using capital in your business. Source of obtaining resources sets in, then allocation continues until their use to repay debts or gain more funds for investment.

In simple words, it is the time gap between the outflow and inflow of cash into the cash register. Simple words: Time gap between the conversion of capital of a company into a product or service that is sold to its clients. That is why it is also known as the “cash cycle”.

Therefore, the shorter the financial cycle, the better for the business, as this means that there is an effective financial organization . Therefore, contrary to what many managers imagine, a negative financial cycle is excellent, as it shows that the company receives payment for the goods sold before it even needs to pay suppliers.

How to calculate it?

The calculation of the financial cycle depends directly on the result of the operating cycle. Simply use the following formula:

financial cycle = operating cycle – average payment term to suppliers

Let’s use the same example of the chair factory? We already know that it has an operating cycle of 84 days.

Let’s say, then, that the average payment term to suppliers is 60 days. Therefore, we have a financial cycle of 24 days. This means that the company pays its suppliers 24 days before receiving the sales value.

In other words, during this period, it is necessary to use working capital to finance your operations. In this sense, one of the ways to reduce the financial cycle is by negotiating better terms with suppliers.

How to effectively manage the operational and financial cycle?

To effectively manage the operational and financial cycle, the following actions must be implemented:

• establish budgets, forecasts and financial goals;
• adjust the stock level to avoid excess or shortages;
• implement efficient collection processes to maximize cash flow and ensure payment of bills on time;
• control expenses, avoiding unnecessary spending and prioritizing those that add value to the business;

Such initiatives could be introduced through technological instruments, including financial management software that helps to automate and integrate processes.

As you can see, knowing the operational and financial cycles of a company is as critical in ensuring that its accounts are well-balanced as it is in defining the best strategies for expanding the business. That is why you must constantly monitor the results and develop tactics that aim to reduce them in order to manage them properly.