By Richard Loth (Contact | Biography)

Expressed as an indicator (days) of management performance efficiency, the operating cycle is a "twin" of the cash conversion cycle. While the parts are the same - receivables, inventory and payables - in the operating cycle, they are analyzed from the perspective of how well the company is managing these critical operational capital assets, as opposed to their impact on cash.

Formula:
Components:

DIO is computed by:
  1. Dividing the cost of sales (income statement) by 365 to get a cost of sales per day figure;
  2. Calculating the average inventory figure by adding the year's beginning (previous yearend amount) and ending inventory figure (both are in the balance sheet) and dividing by 2 to obtain an average amount of inventory for any given year; and
  3. Dividing the average inventory figure by the cost of sales per day figure.
For Zimmer Holdings' FY 2005 (in $ millions), its DIO would be computed with these figures:

(1) cost of sales per day 739.4 ÷ 365 = 2.0
(2) average inventory 2005 536.0 + 583.7 = 1,119.7 ÷ 2 = 559.9
(3) days inventory outstanding 559.9 ÷ 2.0 = 279.9

DSO
is computed by:

  1. Dividing net sales (income statement) by 365 to get net sales per day figure;
  2. Calculating the average accounts receivable figure by adding the year's beginning (previous yearend amount) and ending accounts receivable amount (both figures are in the balance sheet) and dividing by 2 to obtain an average amount of accounts receivable for any given year; and
  3. Dividing the average accounts receivable figure by the net sales per day figure.
For Zimmer Holdings' FY 2005 (in $ millions), its DSO would be computed with these figures:

(1) net sales per day 3,286.1 ÷ 365 = 9.0
(2) average accounts receivable 524.8 + 524.2 = 1,049 ÷ 2 = 524.5
(3) days sales outstanding 524.5 ÷ 9.0 = 58.3
DPO is computed by:
  • Dividing the cost of sales (income statement) by 365 to get a cost of sales per day figure;
  • Calculating the average accounts payable figure by adding the year's beginning (previous yearend amount) and ending accounts payable amount (both figures are in the balance sheet), and dividing by 2 to get an average accounts payable amount for any given year; and
  • Dividing the average accounts payable figure by the cost of sales per day figure.
For Zimmer Holdings' FY 2005 (in $ millions), its DPO would be computed with these figures:

(1) cost of sales per day 739.4 ÷ 365 =2.0
(2) average accounts payable 131.6 + 123.6 = 255.2 ÷ 125.6
(3) days payable outstanding 125.6 ÷ 2.0 = 63

Computing OC
Zimmer Holdings' operating cycle (OC) for FY 2005 would be computed with these numbers (rounded):

DIO 280
DSO +58
DPO -63
OC 275

Variations:
Often the components of the operating cycle - DIO, DSO and DPO - are expressed in terms of turnover as a times (x) factor. For example, in the case of Zimmer Holdings, its days inventory outstanding of 280 days would be expressed as turning over 1.3x annually (365 days ÷ 280 days = 1.3 times). However, it appears that the use of actually counting days is more literal and easier to understand.

Commentary:
As we mentioned in its definition, the operating cycle has the same makeup as the cash conversion cycle. Management efficiency is the focus of the operating cycle, while cash flow is the focus of the cash conversion cycle.

To illustrate this difference in perspective, let's use a narrow, simplistic comparison of Zimmer Holdings' operating cycle to that of a competitive peer company, Biomet. Obviously, we would want more background information and a longer review period, but for the sake of this discussion, we'll assume the FY 2005 numbers we have to work with are representative for both companies and their industry.

Days Sales Outstanding (DSO):
Zimmer 58 Days
Biomet 105 Days

Days Inventory Outstanding (DIO):
Zimmer 280 Days
Biomet 294 Days

Days Payable Outstanding (DPO):
Zimmer 63 Days
Biomet 145 Days

Operating Cycle:
Zimmer 275 Days
Biomet 254 Days

When it comes to collecting on its receivables, it appears from the DSO numbers, that Zimmer Holdings is much more operationally efficient than Biomet. Common sense tells us that the longer a company has money out there on the street (uncollected), the more risk it is taking. Is Biomet remiss in not having tighter control of its collection of receivables? Or could it be trying to pick up market share through easier payment terms to its customers? This would please the sales manager, but the CFO would certainly be happier with a faster collection time.

Zimmer Holdings and Biomet have almost identical days inventory outstanding. For most companies, their DIO periods are, typically, considerably shorter than the almost 10-month periods evidenced here. Our assumption is that this circumstance does not imply poor inventory management but rather reflects product line and industry characteristics. Both companies may be obliged to carry large, high-value inventories in order to satisfy customer requirements.

Biomet has a huge advantage in the DPO category. It is stretching out its payments to suppliers way beyond what Zimmer is able to do. The reasons for this highly beneficial circumstance (being able to use other people's money) would be interesting to know. Questions you should be asking include: Does this indicate that the credit reputation of Biomet is that much better than that of Zimmer? Why doesn't Zimmer enjoy similar terms?

Shorter Is Better?
In summary, one would assume that "shorter is better" when analyzing a company's cash conversion cycle or its operating cycle. While this is certainly true in the case of the former, it isn't necessarily true for the latter. There are numerous variables attached to the management of receivables, inventory and payables that require a variety of decisions as to what's best for the business.

For example, strict (short) payment terms might restrict sales. Minimal inventory levels might mean that a company cannot fulfill orders on a timely basis, resulting in lost sales. Thus, it would appear that if a company is experiencing solid sales growth and reasonable profits, its operating cycle components should reflect a high degree of historical consistency.

Proceed to the next chapter on Cash Flow Indicator Ratios here.
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