Maximisation of shareholders’ wealth of a firm is possible only when there are sufficient returns from their operations. But profits can be earned will naturally depend, among other things, upon the magnitude of the sales. In other words, successful sales activity is necessary for earning profits. Sales do not convert into cash immediately. There is an invisible time lag between the sale of goods and receipt of cash. There is, therefore, a need for working capital. In other words, sufficient working capital is necessary to sustain sales activity. The operating cycle concept penetrates to the heart of working capital management in a more dynamic form. The time that elapses to convert raw materials into cash is known as operating cycle. In other words, the time that elapses between the purchase of raw materials and the collection of cash for sale is referred to as the operating cycle.
To quote Joy, The continuing flow from cash to suppliers, to inventory, to accounts receivables and back into cash is what is called the operating cycle. The operating cycle involves the following procedure:
1. Conversion of cash into raw materials.
2. Conversion of raw materials into work-in-process.
3. Conversion of work-in-process into finished goods.
4. Conversion of finished goods into sales [debtors and cash].
If a firm sells well on a cash basis with (4) operating cycle then returns to the operating cycle (1). But if firm sells goods on credit basis then there will be another cycle that is, Conversion of debtors into cash.
The stock of raw material is held in order to ensure smooth production. Similarly, stocks of finished goods have to be carried to meet the demand from the consumers on the continuous basis. Goods are sold on credit for competitive reasons. Thus, an adequate amount of funds has to be invested in current assets for a smooth and uninterrupted production and sales process.
The operating cycle will be different in different types of business units:
1. Operating Cycle of Manufacturing Firm: The above-stated cycle will be suitable to a manufacturer firm.
2. Operating Cycle of a Non-manufacturing Firm: Non-manufacturing firms are wholesale sellers and retailers, which do not have manufacturing process. They will have the direct conversion of cash into finished goods and then into cash. In other words, they will purchase finished goods from manufacturing firm and sell them either for cash or credit.