The working capital cycle for most companies involves several key steps:
- Material acquisition: Initially, materials are purchased on credit, allowing production without immediate cash outlay. This step ensures a steady supply of resources for manufacturing.
- 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.
- 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.
Components of the working capital cycle
The working capital cycle is made up of three main components that directly influence cash flow and business efficiency:
Inventory
- Role of Inventory in the Cycle: The inventory turnover period reflects the time from purchasing raw materials to selling finished goods. Efficient inventory management prevents overstocking and waste, helping shorten the working capital cycle.
- Managing Inventory Levels: Businesses should adopt smart inventory practices to maintain optimum stock levels, ensuring smooth turnover without delays or excess.
Accounts Receivable
- Definition and Significance: The accounts receivable period covers the time between making a sale and receiving customer payment. Proper receivables management strengthens cash flow and reduces the length of the cycle.
- Strategies for Efficient Accounts Receivable Management: Timely invoicing and consistent follow-up on payments can help reduce delays and speed up collections.
Accounts Payable
- Understanding Accounts Payable: This refers to the time between procuring resources from suppliers and making payments.
- Optimising Payment Terms: Negotiating favourable terms with suppliers ensures cash outflows align with business needs, leading to a smoother working capital cycle.
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
How to calculate the working capital cycle
Assume a company has an average inventory of ₹50,000, a cost of goods sold of ₹100,000, average accounts receivable of ₹25,000, annual credit sales of ₹200,000, and average accounts payable of ₹20,000.
- Inventory days = (₹50,000 / ₹100,000) x 365 = 182.5 days
- Accounts receivable days = (₹25,000 / ₹200,000) x 365 = 45.63 days
- Accounts payable days = (₹20,000 / ₹100,000) x 365 = 73 days
Working capital cycle = 182.5 + 45.63 – 73 = 155.13 days
This indicates that the company takes an average of 155.13 days to turn its current assets into cash and settle its current liabilities.
What affects the working capital cycle?
Several factors influence the working capital cycle. Efficient inventory management is crucial, as it reduces holding costs and frees up cash, thereby shortening the cycle. The speed at which accounts receivable are collected also plays a significant role; faster collections improve cash flow and reduce the cycle length. Extending payment terms with suppliers can delay cash outflows, which affects the cycle by potentially lengthening it. Additionally, higher sales volumes may lead to increased inventory and receivables, potentially lengthening the cycle. Operational efficiency is another factor; streamlined operations and reduced lead times can accelerate turnover rates, impacting the cycle duration. Lastly, economic conditions and market demand fluctuations can affect cash flow and working capital needs, further influencing the cycle.
Positive vs. negative working capital cycle
Aspect
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Positive Working Capital Cycle
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Negative Working Capital Cycle
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Cash Flow
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Cash inflow exceeds outflow, ensuring liquidity and financial stability.
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Cash outflow surpasses inflow, potentially leading to liquidity issues and financial strain.
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Inventory Management
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Inventory turnover is slow, indicating surplus stock and potential inefficiencies.
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Rapid inventory turnover reduces holding costs but may result in stockouts and missed sales opportunities.
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Accounts Receivable
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Lengthy collection periods improve cash flow but may signal credit risks and delayed payments.
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Short collection periods expedite cash inflow but may strain customer relationships and limit sales.
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Accounts Payable
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Longer payment terms provide flexibility but can strain supplier relationships and result in missed discounts.
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Short payment terms improve cash flow but may damage supplier relationships and limit access to credit.
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Overall Efficiency
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Slower turnover rates may indicate inefficiencies in operations and resource allocation.
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Faster turnover rates suggest efficient operations but require careful management to avoid stockouts and cash flow disruptions.
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Financial Health
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Positive working capital cycle signifies stability and resilience in managing day-to-day operations.
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Negative working capital cycle may signal financial distress or overreliance on short-term financing.
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Working capital cycle in financial modelling
The Working Capital Cycle in financial modelling 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 modelling incorporates this cycle to assess a company's operational efficiency, liquidity position, and overall financial health. By analysing the components of the working capital cycle, businesses can optimise 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, optimise 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.
Additional Read: Capital Budgeting
Why working capital cycle is 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?
The key drivers that can enhance the working capital cycle of a company are as follows:
Working Capital Changes
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Description
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Reduction in Days Inventory Outstanding (DIO)
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- Reducing the period inventory stays idle helps improve efficiency. Effective inventory management involves analysing past demand trends and placing orders accordingly.
- Management must also adjust order sizes considering seasonality, demand cycles, and changing consumer needs.
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Contraction in Days Sales Outstanding (DSO)
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- The company collects payments from credit customers faster, improving cash flow.
- For example, automated invoicing systems that remind customers of dues can speed up payment collections and reduce delays.
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Extension in Days Payable Outstanding (DPO)
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- With greater scale and stronger negotiation power, companies can extend payment deadlines without straining supplier relationships.
- Larger companies often secure favourable credit terms from suppliers and vendors.
- Suppliers with few clients may agree to longer payment terms to avoid losing an important customer.
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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, and exploring options like a business loan, businesses can improve cash flow, reduce risks, and build a solid foundation for growth.
