Everything You Need to Know About the Life Cycle of Working Capital
Working capital cycle can be defined as the time taken by an organization to convert its net current assets and current liabilities into cash. It reflects the ability and efficiency of the organization to manage its position of short-term liquidity. In other words, the working capital, which is usually calculated in days, is the time duration between buying goods to manufacture products and generation of cash revenue on selling the products. The shorter the cycle, the faster a company is able to free up its cash stuck in working capital. If the cycle is too long, then the capital gets locked in the operational cycle without earning any returns. Therefore, a business attempts to shorten the working capital cycle to improve the short-term liquidity conditions and enhance overall efficiency.
The working capital cycle focuses on the management of 4 key elements- cash, receivables (debtors), payables (creditors), and inventory (stock). The duration of the working capital cycle varies according to the nature of business. If a business has absolute control over these four items, it will lead to a fairly efficient working capital cycle. It is calculated as follows:
Working Capital Cycle= Inventory turnover in days + debtor turnover in days – creditors turnover
A company can endeavour to shorten its working capital cycle in the following ways:
- Reduction of the credit period given to its customers and thereby bringing down the average collection period. Giving cash discount can also help improve the debtor’s turnover ratio or average collection period amidst various other ways.
- The company can take steps to improve or streamline its process of manufacturing and focus on different ways of increasing sales. This will, in turn, reduce the time taken for inventory to convert to sales. The earlier the stock clearance, the better is the working capital cycle.
- Working capital cycle can also be reduced by a better negotiation to increase the credit period from suppliers of raw material and goods required for production.
Most businesses fail to finance the operating cycle (average collection period + inventory turnover in days) with accounts payable financing alone. A working capital loan can come to one’s rescue during such times. A business can manage this shortfall with either profits accumulated over time or by borrowed funds or both. The various sources of funding that can be used to manage the gaps in working capital cycle include- lines of credit, trade credit, factoring, short term small business loan, etc.
On the other hand, the following are the reasons for a longer operating cycle:
- Unavailability of raw materials can lead to longer working capital cycle as the organization will have to hold large amount of raw materials in stores.
- The processing period may be longer. The nature of the product is such that the product passes through various departments till it is finished.
- If the product is slow-moving, the time taken to deplete the finished goods stock will be longer, thus resulting in a longer working capital cycle.
Often, the credit policy and the inefficiency of the organization in debt collection are also responsible for increasing the length of the operating cycle.