Explain different stages involved in operating cycle. Distinguish between gross operating capital and net working capital.

Introduction

The operating cycle, also known as the cash conversion cycle, is a key concept in financial management. It refers to the time taken by a business to convert its investments in inventory and other inputs into cash flows from sales. Understanding its stages and the associated concepts of gross operating capital and net working capital is essential for effective working capital management.

Stages of Operating Cycle

The operating cycle involves several stages that track the flow of cash through a business. The typical stages include:

1. Purchase of Raw Materials

This is the first stage where the company buys raw materials required for production. The expenditure made here is in the form of cash or credit.

2. Conversion into Work-in-Progress (WIP)

Raw materials are processed in various production stages. The WIP includes materials, labor, and overheads.

3. Conversion into Finished Goods

Work-in-progress is converted into finished goods ready for sale.

4. Sale of Finished Goods

Finished goods are sold to customers. Sales may be cash or on credit. Credit sales delay cash inflow and extend the operating cycle.

5. Collection of Accounts Receivable

This is the final stage where the business collects payments from customers. Once cash is received, the cycle is complete and can begin again.

Formula for Operating Cycle

Operating Cycle = Inventory Conversion Period + Receivables Collection Period

Example:

If Inventory Period = 60 days and Receivables Period = 30 days, then:
Operating Cycle = 60 + 30 = 90 days

Gross Operating Capital vs. Net Working Capital

These are two related but distinct concepts in working capital management.

Gross Operating Capital:

• It refers to the total investment in current assets such as cash, accounts receivable, and inventory.
• It does not take into account current liabilities.
• Gross Operating Capital = Total Current Assets
• Example: Inventory = ₹1,00,000, Receivables = ₹50,000, Cash = ₹20,000; Gross Operating Capital = ₹1,70,000

Net Working Capital:

• It is the difference between current assets and current liabilities.
• It indicates the liquidity position and ability to meet short-term obligations.
• Net Working Capital = Current Assets – Current Liabilities
• Example: If Current Liabilities = ₹90,000, then Net Working Capital = ₹1,70,000 – ₹90,000 = ₹80,000

Differences at a Glance

Conclusion

The operating cycle plays a pivotal role in financial management by helping companies manage cash flow effectively. Understanding its stages and the distinction between gross operating capital and net working capital allows firms to optimize operations, ensure liquidity, and maintain profitability.