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1 what are four general phases of the working capital cycle

Working Capital Cycle

Working Capital cycle WCC refers to 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 short-term liquidity position.

In other words, the working capital cycle 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 working capital cycle, the faster the company is able to free up its cash stuck in working capital. If the working capital cycle is too long, then the capital gets locked in the operational cycle without earning any returns.

Therefore, a business tries to shorten the working capital cycles to improve the short-term liquidity condition and increase their business efficiency. The working capital cycle focuses on management of 4 key elements viz.

  • A company takes raw materials on credit and has to pay back to its creditors in few days say 30 days in our example;
  • This means that the company enjoys a credit period of 30 days on the purchase of raw materials used for the production of the final good.

A business needs to have complete control over these four items in order to have a fairly controlled and efficient working capital cycle. Let us look at an example to enable a better understanding of the concept of working capital cycle. Working Capital Cycle Example Let us assume following details for a company that is in the manufacturing sector.

A company takes raw materials on credit and has to pay back to its creditors in few days say 30 days in our example.

This is also called as average payables period which is can be calculated as the ratio of creditors to credit purchases. This means that the company enjoys a credit period of 30 days on the purchase of raw materials used for the production of the final good. It takes some time for the company to convert its credit sales into cash due to the credit management policy incorporated by the company in terms of the credit period extended to customers.

For inventory to convert to sales, it takes roughly 102 days Conversion of receivables debtors to cash, on an average, takes 55 days Working Capital Cycle Calculation The working capital cycle for the company can be calculated as given below: Every company would like to keep its working capital cycle as short as possible. A shorter working capital cycle can be achieved by focusing on individual aspects of the working capital cycle. Let us see how this works: How to Shorten Working Capital Cycle?

A company can aim to shorten its working capital cycle by: Reducing the credit period given to its customers and thereby reducing the average collection period. The earlier the stock clearance better is the working capital cycle.

A better negotiation to increase the credit period from suppliers of raw material and goods required for production can also aid reduction in the working capital cycle. While the average collection period and credit period from suppliers aid in shortening the working capital cycle, the initial prime focus of the business should be to reduce the time taken for inventory to convert to sales.

If the time taken is very long it could imply that the business is not able to generate sales for the goods produced and more and more capital gets locked in inventory. Either the business should try and reduce the time or should reduce the amount of inventory thereby reducing the amount locked in working capital.

In other words, if the business is not able to reduce its working capital cycle and has higher inventory levels, it should aim at reducing inventory levels and reduce the amount locked in the working capital keeping the cycle time length same.

  1. Working capital cycle in a manufacturing company as seen above in the example is usually positive as there is a time lag between the goods produced and goods sold time is taken for inventory to convert to sales. Working capital as technically defined current assets less accounts payable and accrued expenses increases by the profit earned on the sale.
  2. Adding Labor and Other Costs Conversion is the process of adding labor to the materials and bringing a product to the final stage of readiness for the customer. All of the above are balance sheet related, think about the income statement improvement too.
  3. A usual order is two sets 4,000 spacers which Bob keeps in inventory. If the working capital cycle is too long, then the capital gets locked in the operational cycle without earning any returns.
  4. Other industries are extremely labor intensive like movie production or even putting together a musical concert. A company can aim to shorten its working capital cycle by.

This shortfall can be managed by the business either out of profits accumulated over time, borrowed funds or by both. Let us look at the sources of funding which can be used to manage the gaps in working capital cycle. It can be useful to read about a similar metric Days of Working Capital.

  1. Notice several key changes of business after completing this sale.
  2. The same can be paid off once sales proceeds are collected from debtors. Adding Labor and Other Costs Conversion is the process of adding labor to the materials and bringing a product to the final stage of readiness for the customer.
  3. A company can aim to shorten its working capital cycle by. During the process the debit balances in the raw materials and supplies move down into finished products by simply crediting raw materials along with supplies reducing their balances and debiting finished products.
  4. The same can be paid off once sales proceeds are collected from debtors. A meter is installed and the system is wrapped with electrical heating tape for wintertime compliance.

Sources of Short-Term Working Capital Financing Lines of Credit The Company can borrow from banks for a short-term usually 30 — 60 days against a line of credit given by the bank. The same can be paid off once sales proceeds are collected from debtors.

Trade Credit Often good relations with creditors can be used for extending credit period as one of the cases in case of a large order and enable financing at a lower cost. Factoring Factoring or discounting of receivables can shorten the working capital cycle and generate cash, however, this is usually at a higher cost.

Short Term Loans Companies who may not be able to get a line of credit may look for the short-term working capital loan from a bank. Having briefly known the sources of working capital financinglet us understand the nature of the working capital cycle: The nature or the length of the working capital cycle differs from business to business and varies among sectors.

Cash and Working Capital Essay

Working capital cycle in a manufacturing company as seen above in the example is usually positive as there is a time lag between the goods produced and goods sold time is taken for inventory to convert to sales. However, there is a possibility of a negative working capital cycle in specific businesses. Negative Working Capital Cycle Let us look at the business model of a supermarket or hypermarket chain.

The business is a supermarket and hence, all items in the store are taken from vendors and have a credit period availability to be paid.

So usually such businesses enjoy the huge cash and even may make interest earning on the cash till the money needs to be paid to the suppliers. Therefore, these companies have a negative working capital cycle.

Conclusion Given that the working capital cycle can range from negative to large positive, one needs to answer the question as to what is the optimum level of working capital cycle. Basically, one cannot arrive at thumb rules as working capital cycle varies from sector to sector.

Comparison with peers in the similar industry is more meaningful when analyzing companies and its operating efficiency. Moreover, the working capital cycle may fluctuate depending upon the product manufactured, their seasonality, and shelf life along with many other factors.

Sometimes poor forecasting, change in government policies and unexpected events may change the working capital cycles and add up to working capital financing problems. The level may also depend on the future plans, sales forecast, product diversification etc.