What is Net Operating Cycle?
The net operating cycle, also called the 'cash conversion cycle,' is the number of days it takes a company to generate revenues with assets.
How Does Net Operating Cycle Work?
Analysts can calculate the length of the cycle with the following formula:
Net Operating Cycle = Days Inventory Outstanding + Days Sales Outstanding + Days Payables Outstanding
Note that DPO is a negative number.
The net operating cycle involves determining how long it takes to create inventory, sell inventory and collect on invoices to customers. For example, let's say Company XYZ makes widgets, which typically sit in the warehouse for 10 days. Let's also assume that it typically takes 15 days to collect on the sale of each widget, and that it takes 14 days to pay invoices to Company XYZ's vendors. Using the formula above, Company XYZ's net operating cycle is:
Net Operating Cycle = 10 + 15 + -14 = 11 days
This means that Company XYZ generates cash from its assets within 11 days.
Why Does Net Operating Cycle Matter?
The net operating cycle is a measure of how long an investment is locked up in production before turning into cash.
Changes in net operating cycle can be very telling. For example, when companies take a long time to collect on outstanding bills, or they overproduce and fill up the warehouse because they can't figure out what sells, their net operating cycles lengthen. For small businesses especially, long net operating cycles can be the difference between profit and bankruptcy. After all, companies can only pay for things with cash, not profits. In turn, the net operating cycle is a measure of managerial competency as well as operational efficiency.
It is important to note that different industries have different capital requirements and standards, and determining whether a company has a long or short net operating cycle should be made within that context.
