Working Capital Cycle: Definition & Complete Overview

Every business, whether it's a small retailer or a large manufacturing company, has a working capital cycle. This cycle not only determines the health of cash flow but also the ability to gather funds. The working capital cycle is also one of the most effective measures of liquidity management. This blog discusses the working capital cycle, its meaning, importance, benefits, and the formula to calculate.

What is Working Capital Cycle?

The working capital cycle refers to the time a business takes to convert its net current assets into cash. It measures how quickly a company can turn its investments in inventory and other resources into cash flow.

When you are running a business, you always need funds to pay suppliers, salaries, raw materials, and more. Beyond these payments and purchases, maintaining a good cash flow is also essential. A working capital cycle (WCC) demonstrates the time it takes you to convert your net assets and liabilities into cash.

Also Read: Different Types of Working Capital & How to Calculate It?

Components of Working Capital Cycle

• Current Assets: These are the assets that can be changed into cash over one year or one business year. It includes prepaid expenses, accounts receivable, inventory, and short-term investments.
• Current Liabilities: These are debts and obligations that you are required to pay in one year or one business year. Short-term expenses, income taxes, payable interest, payroll due, rentals, etc., are all current liabilities.

Working Capital Cycle Example

A shorter cycle indicates that a business recovers money faster and can reinvest it quickly. A longer cycle means cash is tied up in operations, which can create liquidity pressure. If a business buys raw materials on credit, manufactures goods, sells them, and then collects payment after 60 days, its working capital cycle is 60 days. Thus, WCC is a critical metric for financial health and operational efficiency.

Why is the Working Capital Cycle Important?

Working Capital Cycle is a key measure of sound financial management. Here are all the reasons why the working capital cycle is important:

• Cash Flow Management: Businesses can anticipate cash requirements, stay liquid, and prevent cash crunches by tracking the working capital cycle. It provides insight into the rate at which inventory is converted into cash.
• Efficient Resource Utilisation: A reduced working capital cycle enables businesses to get cash out of operations sooner, optimise inventory levels, and reduce the costs associated with it. This efficiency frees capital for core operations and new opportunities.
• Better Creditworthiness: Tightly controlled cycles are viewed as financially sound companies that can pay on time and are unlikely to default. This reputation can be converted into more favourable loan conditions and relationships with lenders.
• Better Supplier Relationships: Well-managed cycles guarantee suppliers receive their payment on time and assist businesses in negotiating good terms and prices. This builds trust and relationships with the suppliers.
• Informed Decision-making: Working capital cycle helps you, as a business leader, to make informed decisions on inventory purchases, customer credit policies, and financing requirements. It is essential to keep the business agile in a dynamic business environment.
• Increased Profitability: The faster cash flows move, the lower the cost of borrowing and the sooner companies can reinvest funds directly into profitability and support growth.

Also Read: What is the Working Capital Turnover Ratio?

Positive vs Negative Working Capital Cycle

Here are the two primary types of working capital cycles you must know as a business owner:

Positive Working Capital Cycle

A positive working capital cycle occurs when the current business assets exceed the current liabilities. It allows the business to pay suppliers before receiving cash from customers, leading to a cash gap.

Negative Working Capital Cycle

In negative cycles, payables days exceed inventory and receivables days. This means the company receives cash from customers before paying suppliers, a sign of strong liquidity management.

Positive vs Negative Working Capital Cycles

How is the Working Capital Cycle Calculated?

Here is the working capital cycle formula you can use to calculate the cycle in days:

• Working Capital Cycle in Days = Inventory Days + Receivable Days - Payable Days

Suppose:

• Inventory holding period = 40 days
• Receivable period = 35 days
• Payable period = 25 days

Working Capital Cycle = 40 + 35 - 25 = 50 days

This implies that it requires 50 days to turn the investments that the business has made in raw materials into cash.

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

Working Capital Cycle Stages

The working capital cycle phases are the cash flow in various parts of a business. Here are the different stages of the operating cycle of working capital:

1. Buying of Raw Materials (Payables Stage): Businesses purchase raw materials or goods through suppliers on credit. The credit period, e.g., 30 days, gives temporary relief against immediate cash outflow.
2. Holding Inventory: After buying materials, they are transformed into finished products. This step is an evaluation of inventory turnover. Excessive inventory raises storage expenses, and insufficient inventory can interfere with sales.
3. Selling Goods (Receivables Stage): In this stage, complete products are sold, occasionally on credit, which generates accounts receivable.
4. Collecting Cash: In the last stage, customers pay in cash. The faster this occurs, the less time the working capital cycle will take and the better the business will be.

Practical Tips to Reduce Working Capital Cycle

Here are the practical tips you can follow to reduce the working capital cycle:

• Manage Inventory Efficiently: Avoid stacking up more inventory than required. Correctly forecast market demand and stack only the necessary amount to reduce holding costs.
• Accelerate Receivables Collection: Collect early payments from customers with strong follow-ups.
• Optimise Payment to Suppliers: Negotiate longer payment terms with suppliers to ensure that the repayment doesn't impact cash flow.
• Cash Flow Forecasting: Adopt rolling short-term cash flow forecasts in all departments. Project cash flows in advance, respond promptly to deficits, and match operational activities with working capital.
• Embrace the Latest Technology: Implement digital payment and collection systems to accelerate accounts payable/receivable operations.

Also Read: Working Capital vs. Term Loan - Meaning and Difference

Conclusion

Working capital cycle is one of the most significant indicators of the financial health of your company. It shows the efficiency of the business in turning its resources into cash and points out areas that require improvement, whether it is receivables, inventory, or payables. Maintaining the cycle at equilibrium and efficiency helps companies to reduce their borrowing requirements, enhance their profitability, and allow them to grow.

Frequently Asked Questions

What does the working capital cycle mean?

It is the period required to transform inventory and receivables into cash inflows, payables adjusted.

What are the key elements of the working capital cycle?

The primary processes are inventory purchase, sale of goods (cash/credit), receivables collection, and supplier payment.

Why is a shorter working capital cycle important or preferred?

The shorter cycle implies that the assets are converted to cash more quickly, which enhances liquidity and decreases the dependence on external financing.

What influences the length of the working capital cycle?

Industry standards, economic environment, stock turnover, credit terms, and speed of payment collection can influence the cycle.

What can companies do to shorten their working capital cycle?

You can lower the working capital cycle through better inventory control, quicker receivables collection, and better supplier terms.