working capital cycle meaning

Working Capital Cycle: Definition & Complete Overview

September 15, 2022 • 28693 views

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.

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.

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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.

Working Capital Cycle

Why is the Working Capital Cycle Important?

The Working Capital Cycle is an essential aspect of managing a business's finances. It refers to the length of time between a company's payment for goods and services and the receipt of payment for its products or services. Here are some reasons why it's crucial:

  • Cash flow management: The working capital cycle helps businesses to monitor their cash flow more effectively. By tracking how long it takes to turn inventory into cash, companies can plan their working capital requirements more accurately, ensuring they have enough money to meet their obligations and invest in future growth.
  • Efficient use of resources: By reducing the time it takes to convert inventory into cash, businesses can use their resources more efficiently, lowering their inventory holding costs and freeing up cash for other purposes.
  • Improved creditworthiness: Companies with a shorter working capital cycle are generally seen as more creditworthy. This is because they can more easily meet their financial obligations and are less likely to default on loans or payments.
  • Effective supplier management: A business with a longer working capital cycle may struggle to pay its suppliers on time, which can damage its relationships with them. By improving its working capital cycle, a company can improve its supplier relationships and negotiate better terms and pricing.
  • Better decision-making: Companies that have a good understanding of their working capital cycle can make more informed decisions about when to buy or sell inventory, when to extend credit to customers, and when to seek financing.
  • Increased profitability: A shorter working capital cycle can lead to increased profitability, as it allows businesses to generate cash more quickly, reduce their borrowing costs, and reinvest in their operations.

Overall, the working capital cycle is an essential metric that can help businesses to manage their finances more effectively, improve their creditworthiness, and make better decisions that lead to increased profitability and growth.

Why is the Working Capital Cycle Important?

The Working Capital Cycle is an essential aspect of managing a business's finances. It refers to the length of time between a company's payment for goods and services and the receipt of payment for its products or services. Here are some reasons why it's crucial:

• Cash flow management: The working capital cycle helps businesses to monitor their cash flow more effectively. By tracking how long it takes to turn inventory into cash, companies can plan their working capital requirements more accurately, ensuring they have enough money to meet their obligations and invest in future growth.

• Efficient use of resources: By reducing the time it takes to convert inventory into cash, businesses can use their resources more efficiently, lowering their inventory holding costs and freeing up cash for other purposes.

• Improved creditworthiness: Companies with a shorter working capital cycle are generally seen as more creditworthy. This is because they can more easily meet their financial obligations and are less likely to default on loans or payments.

• Effective supplier management: A business with a longer working capital cycle may struggle to pay its suppliers on time, which can damage its relationships with them. By improving its working capital cycle, a company can improve its supplier relationships and negotiate better terms and pricing.

• Better decision-making: Companies that have a good understanding of their working capital cycle can make more informed decisions about when to buy or sell inventory, when to extend credit to customers, and when to seek financing.

• Increased profitability: A shorter working capital cycle can lead to increased profitability, as it allows businesses to generate cash more quickly, reduce their borrowing costs, and reinvest in their operations.

Overall, the working capital cycle is an essential metric that can help businesses to manage their finances more effectively, improve their creditworthiness, and make better decisions that lead to increased profitability and growth.

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

The working capital cycle represents the time it takes for a company to convert its current assets (such as inventory) into cash, and then use that cash to pay off its current liabilities (such as accounts payable). The formula for working capital cycle is:

Working Capital Cycle Formula= Inventory Days + Receivable Days - Payable Days

Here's a breakdown of the formula with examples:

Inventory Days: The number of days it takes for a company to convert its inventory into sales. The formula for inventory days is:
Inventory Days = (Average Inventory / Cost of Goods Sold) x 365
For example, if a company has an average inventory of Rs.1,00,000 and a cost of goods sold of Rs.5,00,000, the inventory days would be:
Inventory Days = (1,00,000 / 5,00,000) x 365 = 73 days
This means it takes the company 73 days to sell its inventory.

Receivable Days: The number of days it takes for a company to collect payment from its customers. The formula for receivable days is:
Receivable Days = (Accounts Receivable / Total Sales) x 365
For example, if a company has accounts receivable of Rs. 50,000 and total sales of Rs. 10,00,000, the receivable days would be:
Receivable Days = (50,000 / 10,00,000) x 365 = 18.25 days
This means it takes the company 18.25 days to collect payment from its customers.

Payable Days: The number of days it takes for a company to pay its suppliers. The formula for payable days is:
Payable Days = (Accounts Payable / Cost of Goods Sold) x 365
For example, if a company has accounts payable of Rs. 25,000 and cost of goods sold of Rs. 5,00,000, the payable days would be:
Payable Days = (25,000 / 5,00,000) x 365 = 18.25 days
This means it takes the company 18.25 days to pay its suppliers.

Putting it all together, the working capital cycle for this company would be:
Working Capital Cycle = 73 days (inventory days) + 18.25 days (receivable days) - 18.25 days (payable days) = 73 days

This means it takes the company 73 days to convert its inventory into cash and use that cash to pay off its current liabilities. The shorter the working capital cycle, the more efficient the company is at managing its working capital.

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

Aspect

Positive Working Capital Cycle

Negative Working Capital Cycle

Definition

A situation where the company's current assets are more than its current liabilities.

A situation where the company's current liabilities are more than its current assets.

Cash flow

Positive cash flow

Negative cash flow

Inventory management

Lower inventory levels

Higher inventory levels

Accounts receivable

Faster collection

Slower collection

Accounts payable

Longer payment terms

Shorter payment terms

Working capital requirement

Higher working capital requirement

Lower working capital requirement

Financial risk

Financial risk is lower

Financial risk is higher

Examples

Retailers, FMCG companies

Airlines, supermarkets

Note: In a positive working capital cycle, the company has more cash inflow and can use it to invest in its business. In contrast, in a negative working capital cycle, the company has more cash outflow and may need to seek external funding to keep the business running.

How Do I Calculate My Business’s Working Capital Cycle?

Calculating your business’s working capital cycle involves determining the length of time it takes for your company to convert its investments in inventory and other resources into cash. The working capital cycle is a measure of the time it takes for your business to generate cash flow from the sale of its products or services. Here are the steps to calculate your business’s working capital cycle:

1.    Determine your business’s inventory turnover period: This is the length of time it takes for your business to sell its inventory. You can calculate inventory turnover by dividing the cost of goods sold by the average inventory balance during a given period.
2.    Determine your business’s accounts receivable turnover period: This is the length of time it takes for your business to collect payment from customers. To calculate accounts receivable turnover, divide the total amount of sales during a given period by the average accounts receivable during the same period.
3.    Determine your business’s accounts payable turnover period: This is the length of time it takes for your business to pay its suppliers. You can calculate accounts payable turnover by dividing the cost of goods sold during a given period by the average accounts payable balance during the same period.

Add your inventory turnover period and accounts receivable turnover period together and subtract your accounts payable turnover period from the result. The resulting figure is your business’s working capital cycle.

Working Capital Cycle Formula = (Inventory Turnover Period + Accounts Receivable Turnover Period) - Accounts Payable Turnover Period

A shorter working capital cycle indicates that your business is able to quickly generate cash flow, while a longer working capital cycle suggests that your business may face cash flow challenges. By tracking your working capital cycle over time, you can identify areas where you can improve efficiency and optimize your cash flow.

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:

1. 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.

2. Collection of money:

Collect the payment that is yet to be received from the customers and motivate the customers to make the payment earlier.

3. 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.

Why a Shorter Working Capital Cycle can be Good for Your Business?

A shorter working capital cycle indicates that your business can quickly generate cash flow, while a longer working capital cycle suggests that your business may face cash flow challenges. By tracking your working capital cycle over time, you can identify areas where you can improve efficiency and optimize your cash flow. Short working capital has various advantages, such as reduced borrowing costs, improved cash flow, reduced risk of bad debts and stock obsolescence, increased financial flexibility and improved ability to take advantage of business opportunities.

Conclusion

In conclusion, working capital management is a crucial aspect of any business, regardless of its size or industry. Managing working capital efficiently can help a business to maintain sufficient liquidity, improve cash flow, and reduce financial risks. By implementing effective strategies for managing working capital, such as optimizing inventory levels, negotiating favorable payment terms with suppliers, and improving collections from customers, businesses can achieve a competitive advantage and ensure their long-term success. With careful planning and attention to detail, businesses can effectively manage their working capital and achieve their financial goals.

Frequently Asked Questions about Working Capital Cycle

1.    What are working capital cycle ratios?
Working capital cycle ratios, also known as operating or cash conversion cycle ratios, are financial metrics that measure the efficiency and effectiveness of a company's working capital management. These ratios help analysts and investors understand how quickly a company can convert its investments in inventory and accounts receivable into cash.

2.    What is the length of the working capital cycle?
The length of the working capital cycle is the amount of time it takes for a business to convert its current assets into cash, which is then used to pay off its current liabilities. It can also be thought of as the time it takes for a business to complete a full cycle of operations, from purchasing raw materials to selling finished goods and receiving payment.

3.    What is the difference between working capital and working capital cycle?
Working capital refers to the current assets and liabilities that a company has, which are used to fund its day-to-day operations. These include cash, accounts receivable, inventory, and accounts payable. Working capital is a measure of a company's liquidity and its ability to meet its short-term obligations.
Working capital cycle, on the other hand, refers to the time it takes for a company to convert its current assets into cash. It is the time between when a company pays for its raw materials and when it receives payment for the finished product. The working capital cycle includes three main components: the inventory period, the accounts receivable period, and the accounts payable period.

4.    What increases the working capital cycle?
The working capital cycle is the time it takes for a business to convert its current assets (such as cash, inventory, and accounts receivable) into cash. Anything that prolongs the time it takes for a business to convert its current assets into cash will increase the working capital cycle. Some factors that increase working capital cycle include high inventory level, seasonal demand, and lengthy production process among others. 

5.    Is a high working capital cycle good?
In general, a high working capital cycle is not considered to be good because it indicates that a company is taking longer to convert its investments into cash. The longer a company takes to convert its inventory into sales and to collect its receivables, the longer it ties up its funds in working capital, which can limit its ability to invest in growth opportunities or pay its debts.

Disclaimer

We take utmost care to provide information based on internal data and reliable sources. However, this article and associated web pages provide generic information for reference purposes only. Readers must make an informed decision by reviewing the products offered and the terms and conditions. Business Loan disbursal is at the sole discretion of Poonawalla Fincorp.
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Poonawalla Fincorp Team

Our team of expert writers and editors are passionate about providing authentic and valuable information on finance. Our aim is to simplify financial and finance-related concepts. We strive to help our readers become more aware and empowered to make informed financial decisions.

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