Working capital is the measure of a company’s short-term financial health and liquidity. The term working capital also means the difference between the current assets and current liabilities of the company. Current assets are more liquid than fixed assets, so a higher working capital equates favorable liquidity for the company.
What is Working Capital Cycle?
Current assets and liabilities are related to the operational activities of the company. In a sense, working capital management directly relates to the operational efficiency of the company.
In relation to operational efficiency, we can define the working capital cycle as:
“The number of days or time a company takes to turn its current liabilities into current assets”.
In other words, the time required to convert raw materials into goods and cash through sales. Practically, the cycle is not that simpler. It involves raw material purchases from suppliers, work in progress, finished goods, sales, and amounts receivables.
How to Calculate the Working Capital Cycle?
The working capital cycle involves three main items of inventory, receivables, and payables. Although these three main components of working capital can further be divided into subcategories, the broader extent of the working capital remains the same.
Formula
Working Capital Cycle = Inventory turnover Days + Accounts Receivable Days – Accounts Payable Days
The inventory turnover can also be divided into raw material, work in progress, and finished goods. For large companies, the three sub-categories can add up to make the final inventory turnover days. For small companies or distributors, the inventory turnover can include only finished goods and holding days only.
Working Example
A company Green Star Co. purchases raw material for garments manufacturing from its suppliers. It transports the raw material from the supplier to its storage and factory. The finished products (Garments) are then sold to the wholesale distributors on credit.
Let us consider the working cycle input component days as:
Inventory turnover Days = 25 Days
Payable days allowed = 100 Days (average)
Receivable Days Achieved = 90 Days (average)
Working Capital Cycle = 25 + 90 – 100 = 15 Days.
Is a positive working capital cycle good for the company? How do we interpret it?
Interpretation and Analysis
In the context of the working capital cycle, three components for calculation play an equally important part in achieving effective results.
A positive working capital cycle as in our example means the company requires more days to receive the cash than to pay. In our example, the company will have to 15 days after selling the finished goods before they receive the cash. It means if the company operates with a positive value, it is losing on cash.
What is a good working capital cycle figure?
Apparently, 15 days of the working capital cycle seems an acceptable figure. The company can cover the shortage of cash with short-term financing options, especially for SME. The true nature and standard of it will vary from the industry and nature of the company business. A manufacturing company with long inventory turnover days and large receivable days can afford to keep a longer working capital cycle. A wholesale distribution company having no work in progress will have to match the industry standards of the short cycle though.
How to Shorten Working Capital Cycle?
Companies would naturally favor a shorter or even negative working capital cycle. As three main components make the cycle, all three can contribute to shortening the working capital cycle.
Accounts Payable Days
The working capital cycle starts with accounts payable days to the suppliers. The company should work with reputable suppliers and agree on terms with extended accounts payable days. The higher the payable days average for the company, the shorter the working capital cycle.
However, the company must consider:
- The extended payable period may result in higher raw material prices
- The suppliers may compromise on the raw material quality
- The company may not be able to replace the suppliers quickly
Inventory Turnover Days
This is the main component of the working capital cycle that a company can directly control. The inventory turnover days can be efficiently managed by increasing operational efficiency. The quicker a company turns its raw material into finished goods, the shorter inventory turnover period will it achieve.
Operational efficiency is directly linked with the availability and skill set of the company. Achieving higher efficiency will require important considerations as:
- Improving the skill set of the operational staff and skilled labor
- Replacing the old machinery with new and efficient ones
- Increasing the working capital financial resources
- Adopting a continuous improvement methodology such as Total Quality Management
- Removing the operational bottleneck hurdles such as unavailability of the raw material
- Reducing idle machine and labor hours
However, achieving higher operational efficiency often increases the input costs for the company. The input costs can directly affect the product’s total costs and pricing decisions.
Accounts Receivable Days
As much as the company would stress extending the accounts payable period for the supplier, it must work to shorten the accounts receivable period. A shorter average receivable period would also reduce the working capital cycle. Again, much like relations with investors, the company would need to consider customer relations here. A shortened receivable would require price discounts, bulk supplies, and quality implications.
Source of Short-Term Working Capital Financing
Any company would inevitably require short-term financing to accommodate the working capital cycle delays. Businesses have several different options to consider the context of working capital and short-term financing needs.
Trade Credits
Trade or merchant credit agreements work between the suppliers and the buyers. The company can opt to make trade credit contracts with the suppliers and buy the raw material on loan terms. The suppliers would require interest and principal repayments.
Bank Overdrafts and Loans
Bank overdraft and short-term loans such as a revolving credit facility are typical solutions for companies looking to manage the working capital. The creditworthiness of the borrowers plays an important role as banks usually do not require any collateral with short-term financing loans.
Leasing Arrangements
The business may consider leasing the high pricing machinery to increase its operational efficiency. It will save the business higher upfront cash requirements. Another option for the company will be to sell and lease back the costly machinery. The company can receive cash and retain the precious machinery to continue its operations.
Invoicing and Factoring
Invoicing or factoring involves the selling of outstanding receivable invoice balances to a third-party on discount. The company may also directly offer invoice discounts to its customers to receive outstanding balances.
In addition to these options, a large organization can raise short-term financing through commercial papers and promissory notes.
Conclusion
A negative or shorter working capital cycle indicates the operational efficiency, higher liquidity, and solvency for the company. However, achieving the shorter working capital cycle requires substantial considerations for the operational efficiency resources, trade discounts, supplier relations, and product pricing decisions. The company may also utilize the short-term financing options to compensate for the delayed working capital cycle.
