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The Operating Cycle - My washing machine or my Business?

Guest post by: Stan Prokop

Article Overview: The article discusses the elements of any firms operating cyle and how asset turnover is as important as sales and revenue . We also introduce the Dupont Formula as a measure of the operating cyle .

The Operating Cycle - My washing machine or my Business?

The ‘operating cycle is a distinct part of any business. Frankly we believe that most business owners intuitively know it exists – they just didn’t know it had a name.

The operating cycle is the repetitive pattern of a turnover of a businesses current assets and liabilities. Let’s examine that in a bit more detail. In essence each business established within their company, and probably within their industry, a repetitive pattern of turnover.

In the first phase of the operating cycle a business, unless it is a service business, buys inventory and materials which they will resell to customers. Normally these goods are obtained on credit. The company buys product, and obviously has an account payable to that supplier. So we find that company paying their supplier, cash goes down and inventory goes up. So far so good.

In phase two of the operating cycle the company sells product to a customer. More often than not it sells on credit – this generates accounts receivable – the good news is that the company can finally record sales, or revenue.

In phase three, the final phase of our operating cycle, the company collects the receivable and converts the entire process we have gone through back into cash.

Yes, our analysis is over simplified, and of course behind all these processes the company has administrative and sales costs that back up the entire operating cycle. All of these costs are in some manner related to the final sale and have some sort of contribution in that regard.

We also need to remember that through the entire process bank loans or working capital facilities regularly turn over.

Each company and industry has a different operating cycle – within each industry some companies are clearly doing better than others.

One of the best know ways to measure a firms operating cycle is a formula created by the DUPONT COMPANY many years ago – not surprisingly the formula is called the DUPONT FORMULA!

The formula looks at relationships, or ratios, in the balance sheet and income statement and provides solid ways of measuring the operating cycle and how it affects a company’s profit, and operations. It provides a lot of insight into how a company can improve profitability by emphasizing asset turn over and showing how it’s important as sales. Even a non- financial person should be able to understand this – we are simply saying that if a company get buy something, sell it, and collect the money fast and start all over that will increase profits over a company who takes twice as long to repeat that entire process . Sales are not always the be all and end all! A company, using DUPONT, can show that even if they make a little less on each sale, but turn over inventory and receivables faster, can do as well or better than the competitor.

In summary, a true understanding of the operating cycle allows a business owner or financial manager to focus on expenses, asset turn over, and margins, and see the inter – relationship of all these three components of a business . Understanding and improving your operating cycle will make your firm a leader, not a laggard, in your industry.

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Article Tags: business operating cycle, Dupont Formula



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