What is a Working Capital Cycle?
The Networking Capital refers to the total length of time that takes a business to convert its all net working capital including all the current assets and the current liability into cash.
In general most of the business complete this cycle by selling the inventory and to the customer and collection the amount of revenue from its routine customer, and then make settlement of payment with the passage of time.
Working Capital Cycle Diagram
Steps / Phases involved in the Working Capital Cycle (WCC)
For most companies, the working capital cycle works as follows:
- Purchase Raw material from the supplier on credit to make the finished goods. Suppose we have 90 days to make payment for raw material.
- In order to achieve the average company have to sell its inventory in 85 days,
- Collection of payment should be made from the customer with 20 days, on average.
According to the above Cycle, the company acquires the raw material from the supplier in order to make the finished good. At the very first time company don’t have any cash expenses because the order had been made on a credit basis.
In 90 days, a company has to pay the amount for the material purchased. 85 days will take on assembling the raw material into finished good and sold to the customer. The finished good will be sold to the customer but the payment not yet received, and this will take further 20 days to collect the amount from debtors. Once cash received and payment to the supplier, the working capital cycle is complete.
Working Capital Cycle Formula
What is the formula for working capital
and How to calculate working capital Cycle ?
Based on the above steps, we can see that the working capital cycle formula is:
WORKING CAPITAL CYCLE CALCULATION
On the basis of the above information we can calculate the WCC as under:
Inventory days = 85
Receivable days = 20
Payable days = 90
Working Capital Cycle = 85 + 20 – 90 = 15
Positive vs Negative Working Capital Cycle
Positive Working Capital Cycle
it refers to the positive cash flow in the business and we consider that there is a normal cycle of working capital. In the above example, we saw a business with a positive, or normal, cycle of working capital.
Normally positive WC is the exceeding of the current assets against the current liability of the business. You can also say that if there is the positive figure of Net Working capital, this will be considered as the positive Working capital. This is a very impressive solution of the company in all tough circumstances. It ensures the company to save it from bankruptcy.
Negative Working Capital Cycle
Sometimes, however, businesses enjoy a negative working capital cycle where they collect money faster than they pay off bills.
Negative working capital is the reverse of Positive WC. In NeWC there is an excess of current liability over current assets. This can also be said Negative net working capital. In this case business financed its liability 100% from the current assets and also some portion from the fixed assets.
Sticking with the example mention before if organization decided to make transaction only on cash basis then in this case there will be no account receivable days.
In this scenario we can calculate with the same formula:
Inventory days = 85
Receivable days = 0
Payable days = 90
Working Capital Cycle = 85 + 0 – 90 = –5
Now company just sell the product and received the payment and give it to the suppliers.
Financing Growth and Working Capital
With the positive cycles, most of the Business Organizations normally require financing in those period of time when they sell out the product to the customer but the payment yet not collect. This is the smart idea and also the reason behind the success of rapid growing companies.
In order to manage this situation companies approach to the lending institution to have financing. those lending institutions like bank normally lend money against some securities like inventory and also in some condition on the basis of account receivables.
working capital cycle example
We can understand this scenario with the help of the example:
Let suppose if the lending institute like Banks believes that your company is capable to convert its current assets into cash at 70% then it is possible that you may receive loan upto 50 % of the cost of your inventory.
Furthermore in other cases, if company apply for the loan on the basis of highly credit-worthy account receivables the bank may finance those receivables (also called “factoring”).
Additionally, if a company sells products to businesses that have high creditworthiness, the bank may finance those receivables (also called “Factoring”) by providing early payment.
With the help of anyone or both of the banking solution. A company can finance its capital to operate its routine operations.