# Working capital cycle

3 mins
22 June 2023

Working capital cycle is an important financial metric that measures the time it takes for a business to turn its current assets into cash. In simple terms, it quantifies the business's efficiency and the speed in which it can generate profit from its investment. Business owners should understand the working capital cycle to improve their business operations and keep their finances in check.

## What is the working capital cycle?

The working capital cycle indicates the time taken for a business to convert its resources like inventory and receivables into cash. It measures the duration between when cash is paid out for resources, and the cash is received from customers. In other words, it measures the period of time required for the business to sell products or services and collect money from customers.

## Steps in the Working Capital Cycle

The working capital cycle for most companies involves several key steps:

1. Material acquisition: Initially, materials are purchased on credit, allowing production without immediate cash outlay. This step ensures a steady supply of resources for manufacturing.
2. Inventory management: Manufactured inventory is sold within an average of 85 days, with sales recorded but payment deferred as goods are sold on credit. This step involves monitoring and controlling inventory levels to meet demand.
3. Receivable days: Payment from customers occurs approximately 20 days after the sale. Accounts receivables are recorded until payment is received, contributing to cash flow management.

The cycle concludes with the receipt of payment, marking the completion of the working capital cycle. This iterative process enables companies to sustain operations, manage cash flow effectively, and balance the need for materials with revenue generation from sales. Efficient working capital management is essential for business stability and growth.

## Working capital cycle formula

The working capital cycle formula calculates the time it takes for a company to convert its current assets into cash. It is calculated by subtracting the average payment period from the sum of the average collection period and the average inventory holding period. This formula helps assess the efficiency of a company's working capital management in managing cash flow and liquidity.

Simply put, Working capital cycle= Inventory days+ Receivable days-Payable days.

## Positive vs. negative working capital cycle

 Aspect Positive Working Capital Cycle Negative Working Capital Cycle Cash Flow Cash inflow exceeds outflow, ensuring liquidity and financial stability. Cash outflow surpasses inflow, potentially leading to liquidity issues and financial strain. Inventory Management Inventory turnover is slow, indicating surplus stock and potential inefficiencies. Rapid inventory turnover reduces holding costs but may result in stockouts and missed sales opportunities. Accounts Receivable Lengthy collection periods improve cash flow but may signal credit risks and delayed payments. Short collection periods expedite cash inflow but may strain customer relationships and limit sales. Accounts Payable Longer payment terms provide flexibility but can strain supplier relationships and result in missed discounts. Short payment terms improve cash flow but may damage supplier relationships and limit access to credit. Overall Efficiency Slower turnover rates may indicate inefficiencies in operations and resource allocation. Faster turnover rates suggest efficient operations but require careful management to avoid stockouts and cash flow disruptions. Financial Health Positive working capital cycle signifies stability and resilience in managing day-to-day operations. Negative working capital cycle may signal financial distress or overreliance on short-term financing.

## How to calculate the working capital cycle?

Working capital cycle is calculated by following three key steps:

1. Inventory turnover period: This is the time between purchasing the raw material and selling the finished product.
2. Accounts receivable period: This is the time taken between selling the product and receiving the payment from the customer.
3. Accounts payable period: This period represents the time gap between receiving the resources and payment to the supplier.

Working capital cycle = (inventory turnover period + accounts receivable period) - accounts payable period.

## Working capital cycle in financial modeling

The Working Capital Cycle in financial modeling represents the time it takes for a company to convert its investments in raw materials into cash from sales. It encompasses inventory turnover, accounts receivable collection, and accounts payable payment periods. A shorter cycle indicates efficient cash flow management, while a longer cycle may strain liquidity. Financial modeling incorporates this cycle to assess a company's operational efficiency, liquidity position, and overall financial health. By analyzing the components of the working capital cycle, businesses can optimize cash flow, improve profitability, and make informed strategic decisions for sustainable growth.

## How to reduce the working capital cycle?

To reduce the working capital cycle, optimize inventory management by implementing just-in-time inventory systems and negotiating favourable payment terms with suppliers. Accelerate receivables collection by offering discounts for early payments and enforcing stricter credit policies. Additionally, extend payables without affecting vendor relationships and consider alternative financing options like invoice financing. Streamlining operational processes and improving efficiency across departments can also shorten the working capital cycle, ultimately enhancing cash flow and liquidity for sustained business growth.

## Why is it important?

The working capital cycle is a critical metric as it indicates the business' profitability and its ability to meet its financial obligations effectively. A shorter cycle means that the business can cover its costs faster, reduce its overheads, and invest in growth opportunities. In contrast, if the cycle is longer, it can cause financial strain as the business has to manage its working capital with inadequate cash flow.

## How to improve the working capital cycle?

Several strategies help to reduce the working capital cycle and improve cash flow:

1. Efficient management of inventory: Businesses should carefully manage stock to avoid stockpiling and prevent wastage.
2. Timely invoicing: Businesses should invoice customers promptly and follow-up on payment to ensure they receive payment as soon as possible.
3. Effective supplier payment terms: Businesses should negotiate favourable payment terms with their suppliers to ensure that they have the cash flow to cover expenses.
4. Managing accounts payable: Businesses should keep careful track of their bills to avoid penalties and preserve their creditworthiness.

## Conclusion

The working capital cycle provides essential insights into a business's financial health and the effectiveness of its operations. Business owners should understand the working capital cycle and consider ways to improve it to achieve financial stability and growth. By taking steps to manage inventory, invoicing and payment terms with suppliers, businesses can improve cash flow, reduce risks, and build a solid foundation for growth.

## Disclaimer

1. Bajaj Finance Limited (“BFL”) is a Non-Banking Finance Company (NBFC) and Prepaid Payment Instrument Issuer offering financial services viz., loans, deposits, Bajaj Pay Wallet, Bajaj Pay UPI, bill payments and third-party wealth management products. The details mentioned in the respective product/ service document shall prevail in case of any inconsistency with respect to the information referring to BFL products and services on this page.

2. All other information, such as, the images, facts, statistics etc. (“information”) that are in addition to the details mentioned in the BFL’s product/ service document and which are being displayed on this page only depicts the summary of the information sourced from the public domain. The said information is neither owned by BFL nor it is to the exclusive knowledge of BFL. There may be inadvertent inaccuracies or typographical errors or delays in updating the said information. Hence, users are advised to independently exercise diligence by verifying complete information, including by consulting experts, if any. Users shall be the sole owner of the decision taken, if any, about suitability of the same.

What is the formula for working capital cycle?

The formula for working capital cycle is: (Average Inventory Period) + (Average Receivables Period) - (Average Payables Period). It measures the time it takes to convert raw materials into cash through sales.

What are the 4 main components of working capital?

The four main components of working capital are:

1. Cash
2. Accounts Receivable
3. Inventory
4. Accounts Payable.

These elements represent the short-term assets and liabilities essential for a company's day-to-day operations.

How does the working capital optimisation cycle work?

The working capital optimisation cycle works by identifying areas where working capital can be improved and implementing strategies to achieve those improvements. This can include reducing inventory holding costs, speeding up the cash conversion cycle, and improving collection times for accounts receivable. By optimising these processes, companies can improve their cash flow and overall financial health.

What are working capital cycle ratios?

Working capital cycle ratios assess a company's efficiency in managing its operating capital. They include metrics like the inventory turnover ratio, accounts receivable turnover ratio, and accounts payable turnover ratio. These ratios measure how quickly a company converts its assets and liabilities into revenue.

What is the length of the working capital cycle?

The length of the working capital cycle varies depending on factors such as industry, business size, and efficiency of operations. It typically encompasses the time it takes to convert inventory into cash, settle accounts payable, and collect accounts receivable, ensuring smooth cash flow for day-to-day operations.

Is a high working capital cycle good?

A high working capital cycle can indicate inefficiencies in operations, such as slow inventory turnover or lengthy accounts receivable collection periods, tying up cash. While it may suggest strong sales, it's generally not ideal, as it can strain liquidity and hinder growth opportunities.