Businesses need a shorter working capital cycle to fund their day-to-day operations such as debts and expenses, a major component of their liquidity.
What is working capital? Working capital is the aggregate value of the current assets of a company, which can be continuously utilized to support the current operations. It helps in understanding the liquidity position of an organization.
Working capital is much more focused on short term – current asset and current liabilities. Ultimately, positive working capital or cashflow ensures that a business has enough funds to support its operating expenses and short-term debts.
Understanding Working Capital Cycle
The working capital cycle is the time duration between paying for raw materials and goods that were bought to manufacture products and the final receipt of cash that’s earned on selling the products.
Take for example, a small or medium sized enterprise (SME) technology company that sells licenses as an affiliate of Cisco for example, they may need to preorder such licenses from a distributor which they sell on to customers with added installation fees. But they may have a long working capital cycle between paying for such licenses (inventory), selling it on to a customer, getting an invoice receivable (trade debtor) and finally obtaining cash from that receivable (cash).
The shorter the working capital cycle, the more effective is the working capital. If the working capital cycle is too long, then capital gets tied up in the operational cycle without earning returns.
As you can see, working capital cycle comprises of three main parts – cash, inventory and debtors. There is a fourth one – creditors (banks and lenders)
For successful cash-flow management, complete control on each of these aspects of the working capital cycle is important.
In the previous example, the SME has to pay its suppliers in 30 days but collects its receivables from customers in 75 days; therefore having a working capital cycle of 45 days. In these 45 days, the company has to meet the day-to-day operational expenses from creditors. These are the signs that lead to distress
Had the working capital cycle been shorter, the company would have enough incoming cash to support operations. SME’s typically have a hard time raising competitive short term loans and thus it is imperative that their working capital cycle be managed adequately via having shorter days receivables ( time it takes customers to pay invoices in days), which then shortens their working capital cycle.