Working Capital Cycle (Operating Cycle)

  • Post last modified:24 February 2024
  • Reading time:20 mins read
  • Post category:Corporate Finance
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What is Working Capital Cycle?

The working capital cycle measures how quickly your company’s assets, such as inventory, are converted into cash in your bank account. When you understand your working capital cycle, you will know exactly how long your money is stuck in stock and when you will be able to use it for operational purposes or to expand your company. The working capital cycle is usually measured in days and the shorter the cycle, the more efficiently your company manages its cash.

Three primary elements influence the working capital cycle:

  • Inventory Days refer to how soon you can sell your stock.

  • Payable Days refer to how quickly you must pay suppliers for stock or raw materials.

  • The time it takes for you to sell your product and get payment from clients, is also known as Receivable Days.

The shorter your working capital cycle, the faster you can transform stock into profit, which is good for your finances and operational costs.

The cycle can be shortened in a number of ways:

  • Increase the time you have to pay your suppliers: Most suppliers will provide you credit for a specific amount of time before requiring you to pay them. A supplier, for example, can expect payment within 30 days. See if you can get your suppliers to agree to extended payment periods. Certain minimum criteria, such as order amounts and values, may be required.

  • More quickly process, manufacture and sell your stock: The less time you spend on inventory, the better. If you have a processing and manufacturing time, do everything you can to keep the pro- cedure as fast as possible while retaining quality. Identify tendencies, such as seasonal fluctuation, if you are storing stock to reduce the amount of time your money is tied up in inventory.

  • Obtain funds from customers more quickly: The final piece of the jigsaw is to get clients to pay you sooner rather than later. On your invoices, you might offer shorter payment periods, as well as a discount or other incentives for paying early.

  • Lines of Credit, Invoice Factoring and Accounts Payable Financing: Finally, certain specialised financial services can supply you with operating cash prior to the completion of your working capi- tal cycle:

    • By offering cash advances based on your outstanding invoices or accounts receivable, invoice factoring and accounts receivable financing can reduce your Receivable Days.

    • Lines of credit are a short-term way to free up cash in your organisation and they are greatest for reducing Inventory Days.

These financing choices may have greater interest and fees, so you will have to weigh those costs against your requirement for operational money sooner.

  • Number of Inventory Days: The days sales of inventory (DSI) financial ratio shows how long it typically takes a business to con- vert its inventory, which includes things that are still being manufactured, into sales in days.

  • Number of Receivable Days: It is the period of time until a bill is collected during which it will be considered unpaid.

  • Number of Payable Days: Days Payable Outstanding (DPO) measures the typical time it takes a business to settle its accounts payable. Days payable outstanding thus represent a company’s ability to control accounts payable. A DPO of 20 indicates that a corporation typically pays its suppliers in 20 days.

Methods of Working Capital Estimation

Working capital requirements can be estimated or analysed using one of three methods: percentage of revenue or sales, regression analysis or the operating cycle technique. Working capital estimation entails calculating future working capital. It should be as precise as feasible since working capital planning will be based on these estimates and banks and other financial institutions will only fund working capital based on these projections.

Percentage of Sales Method

It is a conventional and straightforward way of calculating working capital and its components. Working capital is calculated using this approach based on previous experience. If the link between sales and working capital has been determined to be consistent over time, this relationship may be used to determine future working capital.

This strategy is straightforward, simple to comprehend and effective for forecasting relatively short-term changes in working capital. However, because the assumption of a linear relationship between sales and working capital may not hold in all circumstances, this strategy is not suggested for general usage.

Regression Analysis Method

It is a helpful statistical tool for predicting working capital requirements. It aids in the forecast of working capital requirements after determining the average relationship between sales and working capital, as well as its numerous components, during the previous years. In this case, the least-squares approach is applied.

Cash Forecasting Method

Cash flow forecasting is a method of determining a company’s financial status by keeping track of its finances and predicting where it will go in the future. There are two types of cash flow forecasting methodologies in general:

  1. Forecasting direct cash flow: Short-term forecasting, often known as direct cash forecasting, depicts financial positions at a single point in time. The revenues and disbursements method is another name for it.

    Time period: The direct approach of cash forecasting is good for three months or less. Transactions, such as bills, invoices and taxes are used as inputs.

    Benefits: It forecasts when payments will be made and when the money will be deposited into your bank account. For example, rather than listing conditions based on the invoice date, it forecasts when payment will be received in hand. It is constructed from the ground up by combining regional transaction data into a worldwide prediction. This allows for detailed cash flow insight.

  2. Forecasting indirect cash flow: The indirect technique is the most often utilised method for cash flow forecasting. Long-term projections, ranging from one to five years, are made using this period.

    Inputs: It is most commonly used for longer-term planning. It forecasts cash flows, including investments and borrowing, using a pro forma balance sheet and profit and loss statement.

    Benefits: It helps with long-term expansion, repatriation, FP&A and M&A planning by displaying the amount of cash necessary for planned company operations.

Operating Cycle Method

Working capital may be estimated using the operational cycle idea. The bigger the necessity for working capital, the longer the operational cycle is and vice versa.

A good assessment of working capital requirements is necessary for successful working capital management. Working capital should be sufficient to meet the company’s production requirements. To compute working capital using this approach, you will need to estimate sales or activity levels to establish the amounts of different working capital components.

The expected growth or reduction in sales above the current level should be taken into account when forecasting sales for the following quarter. Following the evaluation, every aspect of working capital must be monitored.

Estimate of Future Working Capital Based on Current Assets and Current Liabilities

To calculate available money for operations and expansion, the working capital formula subtracts what a company owes from what it possesses. Your current obligations (what you owe) are subtracted from your current assets in the working capital calculation (what you have).

A positive number indicates that you have enough money to handle short-term obligations and bills, but a negative number indicates that you are having trouble making ends meet. Let’s take a closer look at each of these.

Assets in Use Now

A current asset is everything that your company owns that can be turned into cash within the next 12 months. They may include the following:

  • Cash-at-bank

  • Equivalents in cash (investments that can be quickly converted into cash, like government bonds)

  • Receivables (accounts receivable) (for example, outstanding invoices)

  • Stockpiles (including raw materials, WIP, finished goods and packaging)

  • Investing in the short-term

  • Expenses that are paid in advance

Liabilities in the Present

Any bills or debts that you have not paid yet are included in your cur- rent obligations, which include:

  • Accounts receivable (for example, supplier payments)
  • Overdrafts at the bank
  • Taxes on sales, wages and income
  • Wages
  • Short-term loans for rent
  • Outstanding charges

Formula for Working Capital

Working Capital = Current Assets – Current Liabilities is the formula for calculating working capital. For example, if a company’s total current assets are 3,00,000 and its total current liabilities are 2,00,000, the company’s working capital is 1,00,000. (Assets – Liabilities).

Formula for Working Capital Ratio

The working capital ratio formula calculates the asset-to-liability ratio or how many times a company’s current obligations can be paid off with current assets.

Working Capital Ratio = Current Assets / Current Liabilities is the working capital ratio. The working capital ratio would be 3,00,000 / 2,00,000 = 1.5, using the values from the balance sheet above as an example.

It is important to understand the ratio because, on paper, two firms with vastly different assets and liabilities may appear to be equal if their working capital statistics were used alone.

A greater ratio indicates that there is more cash on hand, which is typ- ically a positive indicator. A lower ratio indicates that cash is tighter, therefore a sales slowdown might result in a cash flow problem.

Working Capital Requirement Based on Cash Cost

Cash is the most liquid of all funds and it is critical for any firm to keep its operations running smoothly. An organisation should have enough cash on hand to cover any unforeseen gaps in the manufacturing and sales cycle.

The difference between operating current assets and operating current liabilities are referred to as net operating working capital, which is a measure of a company’s liquidity. These figures are frequently the same and are generated from corporate cash plus accounts receivable plus inventory, minus accounts payable and less accrued costs.

Effect of Double Shift Working on Working Capital Requirements

The most significant advantage gained by the company as a result of implementing shift work is the effective utilisation of fixed capital.

In most cases, output may be enhanced and/or doubled without requiring extra fixed capital expenditure to implement a double shift.

However, in the case of working capital, the same concept does not apply. Because double-shift operating necessitates higher working capital for additional materials, labour and overheads.

The effect of working shifts on working capital

The working day at XYZ Ltd. is 8 hours long. In a month, there are 30 working days.

Due to the high demand for the goods, the management wishes to implement a 6-hour double shift. It is also recommended that workers be paid the same per shift as they were previously paid per day.

You must determine the working capital requirements for (1) single-shift working and (2) double-shift working.

Working Capital Policy

Working capital policies, in general, entail defining the sources of funding. Hedging, aggressive and cautious tactics, depending on the risk levels involved, can assist a corporation optimise working capital funding.

The three types of working capital policy are:

Conservative position

This method is used only when a company has to minimise risk to the greatest extent possible. To guarantee low risk, management strictly controls credit limits under this policy. Furthermore, current assets must always be greater than current liabilities to ensure enough liquidity.

Long-term funding alternatives are commonly used by businesses to finance fixed and changing current assets. Short-term sources are used sparingly in low-risk situations. As a result of following a cautious working capital financing approach, funds are underutilised, reducing returns and jeopardising growth.

Bold approach

Aggressive policies, as their name implies, entail the most risk, but also the greatest potential for progress. Companies that use this approach guarantee that their present assets, such as debtors’ worth, are minimised by assuring timely payments or limiting credit sales.

At the same time, management claims that payments to creditors are being postponed to the greatest extent possible. This working capital approach can be used by businesses that want to develop quickly. However, because it entails such a high level of risk, excellent business acumen and financial management skills are required.

Hedging strategy

This method, also known as matching policy, guarantees that a company’s present assets and short-term obligations are constantly in sync. In essence, the goal of this working capital financing programme is to strike a balance between the two extreme methods in terms of risk and prospective growth.

The majority of companies that follow this approach invest in fixed current assets with long-term financing and finance current assets with short-term financing.

Ratio of Short-term Financing to Long-term Financing

Long-term financing allows businesses to better position themselves for long-term objectives while also reducing financial risk. The easiest way to identify the advantages of long-term and short-term finance is to look at how they correlate with different demands.

When a business is starting, it is common to employ short-term, asset-based financing and this form of financing is often utilised for working capital. Short-term, cash-flow-based bank loans are often used when a firm has outgrown short-term, asset-based loans. When a firm reaches a certain size and establishes a track record, it may obtain cash-flow or asset-based, long-term financing, both of which have strategic advantages.

Advantages of Long-term Finance Over Short-term Finance

The differential in maturities is primarily responsible for the advantages of long-term finance over short-term finance. Long-term financing provides extended maturities with a natural fixed rate across the life of the loan, eliminating the need for a swap.

The following are the main advantages of long-term over short-term financing:

  • Aligns capital structure with long-term strategic goals: Long-term financing allows a corporation to match its capital structure with its long-term strategic goals, giving it more time to earn a return on investment.

  • Matches asset base duration to liabilities duration: Long-term financing has a maturity that is more in line with the normal lifespan of the assets acquired.

  • Long-term investor support: Having a long-term connection with the same investor over the life of the financing might be beneficial to a firm.

  • Reduces the company’s interest rate risk: Due to its fixed interest rate, long-term, fixed-rate financing reduces the refinancing risk associated with shorter-term loan maturities, lowering a company’s interest rate and reducing balance sheet risk.

  • Diversifies capital portfolio: Long-term financing gives you more flexibility and resources to cover a variety of cash needs while reducing your reliance on a single source of capital.

Companies should become familiar with all of the distinctions between long-term and short-term finances to properly comprehend the bene- fits. Short-Term Financing has a term of 3-5 years whereas long-term Financing has typically a term of 5-25+ years. Short-Term Financing has a floating rate but long-term financing has a typically fixed rate. Short-Term Financing is supplied by a bank but long-term Financing is supplied by an institutional investor.

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