Working Capital Cycle: Meaning, Calculation & More

Maintaining adequate liquidity is critical not only in your personal life but also in your enterprise. Without this, running your daily operations or improving the revenue figures will be tough. Liquidity further helps your company invest in new infrastructure and new ventures. Generating cash at the right time is vital to make necessary payments without missing out on any opportunities. This is where the working capital cycle concept comes into play.
 

What is Working Capital? 

Working capital provides information about a company's liquidity position. It is the metric used by entrepreneurs to assess their operational efficiency. If your company's working capital is substantial, it indicates that you are capable of investing in new opportunities and scaling up your business. If this figure is low, it means you are having difficulty meeting your daily business expenses and paying off your creditors.
 
When you submit a business loan application, the lender looks at this metric to determine your repayment ability.

What is the Working Capital Cycle?

The working capital cycle is the time your business takes to convert net working capital into cash. You can improve this cycle by quickly selling off your inventory and earning revenue while negotiating longer repayment terms with your supplier. The longer working cycle indicates that the company's assets are tied and that it is running without earning a profit over it.
 

How to Calculate the Working Capital Cycle?

The mathematical formula for the manual calculation of the working capital cycle is as follows. Working Capital Cycle = { (Inventory Days + Receivable Days) – Payable Days}
 
Here,

• Inventory days are the number of days a company holds its inventory before selling it in the market.

• Receivable days are the number of days it takes for the company to receive payment after selling finished goods on credit.

• Payable days are the number of days it takes the company to make payments to the raw material supplier.

If your company's working capital cycle is positive, it means that you receive payment from your customer before paying your supplier.
 

Working Capital Cycle Formula

Here's the formula for the working capital cycle:
Working Capital Cycle Formula = (Inventory Days + Receivable Days) - Payable Days

Where:

• Inventory Days = (Average Inventory / Cost of Goods Sold) x Period Length
• Receivable Days = (Accounts Receivable / Revenue) x 365
• Payable Days = (Accounts Payable / Cost of Goods Sold) x 365

Also Read: What is Working Capital Management? | Definition & How to Calculate

What are the Phrases of the Working Capital Cycle?

The Phrases of the Working Capital Cycle are as follows:

• First, there's the 'Cash' phase, in which you must ensure that money is flowing in and out. 

• Then comes 'Receivables,' which is when you can negotiate terms for your goods and services. 
• Now the 'Inventory' phase follows, in which you must move your inventory off the shelves and into the hands of satisfied customers. 
• Finally, there's 'Billing,' which is the phase meaning you get to pay up and keep the game going!

Positive vs. Negative Working Capital Cycle

Understanding the difference between a positive and negative working capital cycle is crucial for maintaining the company's financial health. Although a negative working capital cycle can pose financial risks, focusing on the benefits of a positive working capital cycle, such as increased cash flow and lower financial risks, can assist you in making strategic business decisions. So it is vital to understand your specific business needs and respond accordingly.

Positive working capital cycle

1. Funds company operations without external financing
2. Good inventory management and efficient cash flow.
3. Robust financial position and lower risk of default

Negative working capital cycle

1. Indicates struggle to pay debts and need for external financing
2. Higher inventory levels and lower cash inflow
3. Poor financial management and higher risk of default

What are the stages of the working capital cycle?

The working capital cycle is divided into three stages. These are–
 

Stage 1

The company purchases raw materials on credit from any supplier in the first stage. Assume that when you purchased your raw materials, the supplier gave you 90 days to make payment.
 

Step 2

The next stage is converting raw materials into finished goods, which the company sells to customers within 85 days of acquiring raw materials but on 15 days' credit.
 

Step 3

In this stage, the company will receive its payment from its customers upon the completion of 15 days. Shortly after the payment clearance, the working cycle stage is completed. 
 

How to Improve Your Working Capital Cycle?

One key way to improve the life of your working capital cycle is to reduce inventory levels. That means keeping just enough inventory on hand to meet demand without overstocking. You can also try to negotiate better payment terms with your suppliers; this gives you more time to pay your bills. Another option is to offer discounts for early payments from your customers to encourage them to pay on time. And finally, make sure you're managing your cash flow effectively by monitoring your expenses and collecting payments on time. Doing these things can improve your working capital cycle and keep your business running smoothly.
 

How to Reduce Your Working Capital Cycle?

 You can reduce the working capital cycle by focusing on the factors that influence it. Here is how. 
 

1. Inventory Management

   Inventories aid in the smooth production of goods. However, businesses can make a mistake by stocking raw materials that will be needed the following season. They do so to save a few rupees. But in reality, they are preventing themselves from taking advantage of a fantastic opportunity by blocking cash.
    
   Also, if you have finished goods, don't keep them for too long to get a better price. Instead, sell them out so that you can receive a new order.
    

2. Try to Collect Your Dues

   If you have several account receivables that were due months ago, try to recover the amount. If you are a retailer, you can make a tempting offer on immediate payment so that customers do not buy on credit and pay the full price right away.
    

3. Negotiate Better Terms

   In order to improve operational efficiency while maintaining sufficient liquidity, try to negotiate better payment terms with suppliers. Paying them too soon before the due date negatively impacts your cash flow and makes you unable to meet necessary expenses.
    

Also Read: Working Capital Loans: What, How, and Where?
 

To Conclude

 
The working capital cycle is a metric that businesses use to assess their operational efficiency. A positive working capital cycle indicates that you receive your customer's payments before paying your supplier and that you do not have to go a day without earning any returns. It is also important in loan approval. A poor working capital cycle can be improved by negotiating better payment terms with suppliers, selling inventories without holding them for an extended period of time, and shortening the credit duration when selling goods to customers.

FAQs

 1. What is the length of the working capital cycle?

The working capital cycle length depends on the business and industry. So how much time it takes for a company to convert its inventory into cash and pay off its current liabilities gives the exact period. Generally, a shorter working capital cycle is better, as it means the company is more efficient in managing its working capital.

2. What are working capital cycle ratios?

Working capital cycle ratios are financial metrics that measure efficiency. These ratios include inventory turnover ratio, receivables turnover ratio, and payables turnover ratio. By analysing these ratios, a company can identify areas for improvement. 

3. What are the advantages of the short working capital cycle?

A short working capital cycle has several advantages, such as improved cash flow, reduced financial risk, and increased profitability. This results in a healthier cash flow and reduces the need for external financing. Additionally, a shorter working capital cycle can increase profitability by reducing the costs associated with carrying inventory.

4. What is the difference between working capital and working capital cycle?

Working capital is the amount of cash and assets a company has available to fund its day-to-day operations. In contrast, the working capital cycle is the time it takes for a company to convert its inventory into cash and pay off its current liabilities. In other words, working capital is the money available to a company, while the working capital cycle is the process of managing that money to maintain a healthy cash flow.