working capital cycle meaning

Working Capital Cycle: Definition & Complete Overview

September 15, 2022 • 193 views
Author: PoonawallaFincorp Category: Business Loan

There is no end to curiosity! Your curiosity brought you here, and terms like working capital cycle, working capital and others can be confusing at times. Businesses are dynamic in nature, which creates a lot of confusion amongst outsiders like us. 
Handling a business requires constant brainstorming and agility. There are constant changes in internal and external factors such as political situation, change in policies, change of leadership in the business and other such factors. 

The unpredictable nature of business makes it tough for business leaders to manage it. You require cash to manage day to day business activities. Hence, it is important to know how your working capital cycle works.

We have curated the below information for better understanding about the working capital cycle and such similar terms used in day-to-day business activities.

Working Capital

Prior to understanding working capital cycle, let us start with the term working capital. Working capital is the difference between net current assets and net current liabilities. In simpler terms, it is the capital which can be used by the company for its daily business operations.

Components of Working Capital

Current Assets

Current Assets refer to the asset which can be converted into cash within one year or one business year of time. Current assets include prepaid expenses, account receivable, inventory, and short-term investments. These assets don’t include long term assets or fixed assets used for business such as real estate, equipment, machinery, etc.

Current Liabilities

It is those debts and obligation that you have to pay within one year or one business year. Current liabilities include short term expenses, income taxes, interest payable, payroll due, rentals. etc.

Also Read: What are the different types of working capital?

What is Working Capital Cycle?

It is the time to taken to convert net assets and net liabilities into cash. There are several day-to-day business activities which required readily available cash. A working capital cycle can be long and short depending upon the time taken to convert into cash.

What are the steps involved in the working capital cycle?

For a majority of companies, the working capital cycle works in four steps.

Step 1: When a company produces a product, they purchase raw material from a supplier on credit. For example, a company purchases raw material, and they have to make the payment in 90 days.

Step 2: After producing the final product, the company sells the product to customers in 85 days.

Step 3: As the product is sold on credit, the company receives the payment in 20 days.

Step 4: Once, the payment is received by the company, the working capital cycle is complete.

Working Capital Cycle Formula

Inventory Days + Receivable Days – Payable Days = Working Capital Cycle

85 + 20 – 90 = 15 days

What are the phrases of working capital cycle?

There are four phrases of working capital cycle which includes cash, receivables, inventory, and billing.

  • Cash: Maintaining a health cash inflow and outflow
  • Receivables: Terms of payment for good and services for money owned.
  • Inventory: Time taken to sell the inventory
  • Billing: Tie taken to make the payment

What is a Positive Working Capital Cycle?

Generally, all businesses have a positive working capital. It means a company is waiting to receive payment to create available cash. Positive working capital indicates that a company has a good short-term health.

What is a Negative Working Capital Cycle? 

Negative working capital cycle occurs when a company collects money quicker than the time required to pay the expenses.

Also Read: Benefits of Working Capital Loan For Small Business

Positive Working Capital Cycle Vs. Negative Working Capital Cycle

Majority of companies operate on positive working capital cycle or have a normal working capital cycle. This indicates that the company is operating on a credit model and has a good short-term health.

It also shows that it can manage its working capital properly. On the other hand, a negative working capital cycle means the company can collect the money faster. Whereas the company working on no credit or only cash system also has a negative working capital cycle.

Inventory Days + Receivable Days – Payable Days = Working Capital Cycle

85 + 0 – 90 = - 5 days

This indicates that the company receives the payment prior to making its payment.

How to shorten your working capital cycle? 

As mentioned above, there are various factors involved in the working capital cycle. To make the working capital cycle shorter, you can:

  • Better management of inventory: You should not hold goods for too long and should order goods that are in demand and are available at a good price.
  • Collection of money: Collect the payment that is yet to be received from the customers and motivate the customers to make the payment earlier.
  • Paying bills on time: Create a balance while making any payment to the supplier. Don’t pay them too early, pay the supplier on time. This will help you to maintain a good relationship with the creditors and suppliers.

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