Question 5 (c)
The operating cycle and its importance in assessing working capital
6 marks
- Time to write
- About 12 minutes
- Topic
- Working capital
Question
Question 5 (c) · 6 marksWhat do you mean by the operating cycle? Why is it important when assessing a firm's working capital requirements?
Reworded from the university paper; the task is the same. The original paper belongs to the University of Delhi. See DU's question bank.
Before you write
Read off the question and its marks
Read from the question
- What do you…?Why…?Two asks in one question: answer both. Where it asks why, give reasons, not a description.
Write it in this order
- Read; underline the asks; jot your points 1 min
- 1 Meaning of the operating cycle and its stages 2 marks 3 min
- 2 Net operating cycle formula and illustration 1 mark 2 min
- 3 Importance in assessing working capital requirements 3 marks 5 min
- Check: every ask answered, key terms underlined 1 min
Easy marks
- Step 1 opens with the meaning: a one-line definition, the quickest mark in it.
Short on time? Trim steps 1 and 3 evenly rather than skip one: each is capped at its own marks.
Try it first. About 12 minutes for 6 marks. Write it out, then open the solution.
Solution
Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.
Meaning. The operating (working capital) cycle is the length of time between the firm paying for materials, holding them as stock, and receiving cash from the sale of the finished goods. It is found by adding the number of days needed at each stage of the cycle:
1The carpenter's cash becomes a cartload of timber.
Raw material storage periodCash is turned into raw materials.
2Saw and hammer turn the timber into half-made chairs.
Conversion (work-in-progress) periodRaw materials into work-in-progress.
3The finished chairs line the store room, ready.
Finished goods storage periodWork-in-progress into finished goods.
4The chairs go out on credit, and Lakshmi's notebook follows the money home.
Debtors' collection periodFinished goods into debtors and debtors back into cash.
- raw material storage period (R): days raw materials are held before issue to production;
- work-in-progress period (W): days taken to convert raw materials into finished goods;
- finished goods storage period (F): days finished goods wait to be sold;
- receivables collection period (D): days taken to collect from debtors;
- less the credit period from suppliers (C): days for which the suppliers finance the materials.
Net operating cycle = R + W + F + D − C. For example, raw materials held 60 days, supplier credit 15 days, production 15 days, finished goods held 30 days and debtors 30 days give 60 − 15 + 15 + 30 + 30 = 120 days.
Why it matters in assessing working capital requirements.
- It measures how long funds stay locked up. Working capital is needed because of the time gap between paying for inputs and realising cash from sales; the longer the cycle, the more funds are tied up in stock and receivables.
- It is the basis of estimation. Working capital needs can be estimated from the holding period of each current asset related to its cost, which is the operating cycle method.
- It shows how the need is financed. Most businesses cannot finance the cycle (receivable days plus inventory days) from supplier credit alone; the shortfall must be met from internal profits or borrowing.
- It shows where to act. Each component has a time and a money dimension. Collecting from debtors faster, holding less stock or getting longer credit from suppliers shortens the cycle, so the firm generates more cash and needs to borrow less.
Where the 6 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Meaning of the operating cycle and its stages | 2 |
| 2 | Net operating cycle formula and illustration | 1 |
| 3 | Importance in assessing working capital requirements | 3 |
| Total | 6 |
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