Operating Cycle

The operating cycle is a fundamental financial concept that describes the time taken by a business to convert its resources into cash through normal operating activities. It measures the period between the acquisition of inventory or inputs and the realisation of cash from sales. In the context of banking, finance, and the Indian economy, the operating cycle is crucial for assessing working capital requirements, liquidity management, credit appraisal, and overall financial efficiency of firms, particularly micro, small and medium enterprises (MSMEs).
In India, where a large proportion of businesses operate with limited capital buffers and uneven cash inflows, the operating cycle plays a decisive role in determining short-term financing needs and the sustainability of business operations.

Concept and meaning of the operating cycle

The operating cycle represents the flow of funds through a firm’s operating activities. It begins with the purchase of raw materials, moves through production and inventory holding, continues with sales—often on credit—and ends with the collection of receivables in cash. The length of this cycle indicates how quickly a firm can recover its invested funds.
A shorter operating cycle implies faster cash recovery and lower dependence on external finance, while a longer operating cycle indicates funds being tied up for extended periods, increasing the need for working capital finance.

Components of the operating cycle

The operating cycle is composed of distinct stages, each of which affects liquidity and financing requirements:

• Raw material holding period, representing the time raw materials remain in storage before entering production.
• Work-in-progress period, covering the duration of the production process.
• Finished goods holding period, reflecting the time goods are stored before being sold.
• Receivables period, indicating the time taken to collect cash from customers after sales.

In some analyses, the payables period is deducted to arrive at the net operating cycle, which reflects the actual period for which a firm’s own funds or borrowed funds are blocked in operations.

Operating cycle and working capital management

The operating cycle is closely linked to working capital management. A longer operating cycle increases the requirement for working capital, as funds remain locked in inventory and receivables for extended durations. Effective management of inventory levels, production efficiency, and credit policies can significantly reduce the operating cycle and improve liquidity.
In India, many firms—especially MSMEs—face elongated operating cycles due to delayed payments, supply chain inefficiencies, and limited bargaining power. This makes working capital finance a critical requirement and places pressure on banks and financial institutions to provide short-term credit facilities.

Relevance in banking and credit appraisal

For banks and financial institutions, the operating cycle is a key parameter in credit assessment and loan structuring. It is used to estimate the borrower’s working capital needs and to determine appropriate credit limits. Banks analyse industry-specific operating cycles to assess whether a firm’s working capital requirement is reasonable and aligned with operational realities.
A mismatch between the operating cycle and the financing structure can lead to liquidity stress and increased credit risk. Consequently, understanding the operating cycle helps lenders design suitable repayment schedules and monitor the efficient use of funds.

Sectoral variations in the Indian economy

The length and structure of the operating cycle vary significantly across sectors in the Indian economy. Manufacturing firms typically have longer operating cycles due to inventory and production processes. Trading firms generally have shorter cycles, while service-oriented businesses may have minimal inventory but longer receivables periods.
Agriculture-related industries often experience seasonal operating cycles, influenced by cropping patterns and market conditions. Infrastructure and construction sectors tend to have very long operating cycles, making them heavily reliant on institutional finance.

Impact on liquidity and financial stability

At a macroeconomic level, widespread elongation of operating cycles can strain the banking system by increasing demand for short-term credit and raising the risk of delayed repayments. Efficient operating cycles contribute to healthier cashflows, reduced non-performing assets, and improved financial stability.
Government initiatives aimed at improving payment discipline, strengthening supply chains, and promoting digital invoicing and payments have a direct bearing on shortening operating cycles, particularly for smaller enterprises.