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.
How to calculate the working capital cycle?
Working capital cycle is calculated by following three key steps:
- Inventory turnover period: This is the time between purchasing the raw material and selling the finished product.
- Accounts receivable period: This is the time taken between selling the product and receiving the payment from the customer.
- 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.
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:
- Efficient management of inventory: Businesses should carefully manage stock to avoid stockpiling and prevent wastage.
- Timely invoicing: Businesses should invoice customers promptly and follow-up on payment to ensure they receive payment as soon as possible.
- Effective supplier payment terms: Businesses should negotiate favourable payment terms with their suppliers to ensure that they have the cash flow to cover expenses.
- 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.
