Working Capital Cycle Explained: Meaning, Steps, and Example (2024)

Surrounded by the jargons of operating finance, one may have come across a plethora of terms like Working Capital, Net Assets, Inventory Turnover Ratio, and possibly even Working Capital Cycle.

However, the Working Capital Cycle may be a tough concept to comprehend.

From what it means, how it is calculated, the steps in the working capital cycle, why it is important, and an example to break it down for better understanding, we explain everything associated with the topic.

While understanding a concept is one thing, putting it into implementation is another.

Thus, we also explain what the outcomes of the working capital cycle reflect- the difference between a positive and negative WC cycle, what working capital management is, and how it can help optimise a business’s working capital cycle.

Suggested Read: What are Different Types of Working Capital? All Explained

What is the Working Capital Cycle?

Working Capital Cycle, or Net Operating Cycle is the time taken by a business to convert its net working capital to cash.

Thus, it reflects the time taken by a business to pay its suppliers after collecting payment from its customers. It can either be positive or negative.

A negative working capital cycle represents that the business receives payment from clients faster than it has to pay suppliers, ie. it has a longer accounts payable period than the accounts receivable period.

A positive working capital cycle reflects that a business is out of cash for a specified number of days until it receives payment from its clients.

Businesses with a short working capital cycle thus enjoy a better cash flow than businesses with a long one.

Suggested Read: Exploring Different Sources of Working Capital Finance

Steps involved in the Working Capital Cycle

Working Capital Cycle works in the following way-

1. Businesses buy goods or raw materials on credit or on extended payment terms, ie. they may not pay cash for the purchase of goods immediately and are given time by the supplier to make the payment later.
2. Finished goods are produced using the materials procured through suppliers and the company sells the finished products to its clients. The business has to do this within the duration provided by the supplier for repayment so it has cash available on the due date.
3. Most companies do not get payment for the goods sold instantly and collect payment at a later date.
4. Once the company gets paid by the client as per the payment terms, the cycle is considered complete.

How to calculate Working Capital Cycle?

The Working Capital Cycle includes Inventory days, Receivable days, and Payable days and is reckoned using the following formula:

Working Capital Cycle = Inventory Days + Receivable days – Payable days

where,

Inventory Days is the time taken by a business to sell its inventories. It is sometimes also referred to as the Inventory period or Inventory Turnover Period.

Receivable Days is the time taken by a business to receive payment from its clients.

Payable Days is the time duration available to a business to pay suppliers. It is sometimes also referred to as Inventory Billing.

Example of a Working Capital Cycle

Let’s assume that a manufacturing business ‘A’ buys raw material on credit terms from a supplier ‘B’.

The terms of the credit sales stipulate that A must pay B after 40 days. Thus, the Payable Days or Inventory Billing in this case would be 40.

The business takes around 20 days for production of goods from the raw materials and subsequently sell the inventory. Thus, the Inventory days in this case would be 20.

Within a supply chain, most businesses function on credit basis. Hence, it is not necessary that A would receive payment for its sales instantly. Let’s assume that A gets paid by its clients in 30 days as per the payment terms.

Thus, the Receivable days in this case would be 30.

Therefore, Working Capital Cycle (WCC) = Inventory Days + Receivable days – Payable days

WCC = 20 + 30 – 40 = 10

Therefore, business A is out of cash for 10 days till it receives payment from its customers.

Thus, in the above example, business A would need a working capital loan to meet its short-term obligations within those 10 days.

Positive Working Capital Cycle Vs. Negative Working Capital Cycle

Positive Working Capital Cycle reflects the length of time for which a business is out of cash to pay its suppliers for the raw material or the inventory it had purchased.

It depicts that the inventory days may be proportionately more than payable days, hinting that the business may be taking more time to sell inventory or receive full payment from its customers, or that the process for collection of money is inefficient.

Negative Working Capital Cycle reflects that the business is able to collect money faster from its customers earlier than it has to pay its suppliers.

On the other hand, the quick collection may reflect that the accounts receivable of a business are quite less, which may or may not be able to cover the company’s short term liabilities.

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Why is the Working Capital Cycle Important?

The Working Capital Cycle is among the important financial metrics to understand the financial health of a business and specifically, its position to meet its short term obligations like paying bills or other operating expenses.

It reflects the ability of a business to convert its net current assets and current liabilities to generate cash flow. A negative cycle reflects that the company may have adequate cash inflows for paying suppliers on time.

A healthy WC cycle also ensures that businesses have available cash to make short-term investments whenever growth opportunities arise.

Thus, it is an important metric for cash flow management and inventory management.

Why a shorter Working Capital Cycle can be good for business

A shorter working capital cycle depicts that the length of time for which a business is out of cash is less. This in turn reflects that the business is able to convert net current assets into a healthy cash flow efficiently.

Moreover, a negative cycle or a negative working capital cycle depicts that a business is able to receive payment from its clients quicker than it is obligated to pay suppliers, reflecting that the business may have available cash in the meantime for any ad-hoc expenditure.

While it is preferable to have a shorter working capital cycle, several external factors influence the working capital cycle a business may have, some of which include- nature of inventory (perishable or non-perishable), the number of days for which suppliers extend credit, logistical hindrances, etc.

Working Capital Management for a shorter Working capital cycle

While a Working capital cycle formula helps understand whether a business has enough cash to finance its current liabilities, proper Working Capital Management is required to optimise the inventory levels of a business to ensure that the business has enough cash to finance its operations.

The Net working capital of a business consists of its current assets and current liabilities.

Within current assets, accounts receivable, deposits in a bank account, inventory, etc are included. Fixed assets like land, machinery, etc are not included in Current Assets.

Within current liabilities, obligations of a firm due within 12 months are included. Thus, loans maturing within a fiscal year or interest payment on long term debts within the fiscal year are components of current liabilities.

Working Capital Management helps optimise the current assets and liabilities such that business maintains a healthy cash flow. To do so, several key ratios are used, called Working Capital Management Ratios, which includes Inventory Turnover ratio, Working Capital Ratio, Collection Ratio.

Taking these key liquidity ratios as parameters, a business could manage its working capital to shorten its Working Capital Cycle.

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