Working capital (WC) refers to funds that are required by a company to meet its short term expenses (within 1 year). It is the life blood of any business, without which the fixed assets cannot operate .
There is a time gap between the production of goods and their actual realization upon sales. This time gap is called working capital cycle or operating cycle . Hence, in simple words, the working capital cycle (WCC) is the amount of time it takes to convert the current assets and current liabilities into cash.
Every business has a working capital cycle. Some businesses may have longer working capital while some may have a shorter one . The duration of working capital cycle depends upon the nature of the business. The longer the working capital cycle is, the more time it takes for your business to get a good cash flow. Hence, the companies must try to reduce the length of their working capital cycle.
FORMULA FOR WORKING CAPITAL CYCLE
Working capital cycle = inventory days + receivable days – payable days
- Inventory days – It refers to the time it takes for a business to sell its inventory.
- Receivable Days – It refers to the time taken by debtors to make payment for goods sold to them.
- Payable Days – It refers to the time taken by the company to make payment to its suppliers for the raw materials used .
REASONS FOR LONGER WORKING CAPITAL CYCLE
A company may have a longer working capital cycle due to the following reasons –
- If the raw material is not available easily , the company will have to store large amount in its stock.
- Use of outdated machinery, technology,
- The product has a long processing period ,i.e it has to pass through various departments to get finished.
- Poor credit policy and inefficiency in collection of debt.
- Failure to get trade discounts and cash discounts.
HOW TO REDUCE WORKING CAPITAL CYCLE ?
Businesses can reduce their working capital cycle by :
- Reducing the credit period given to the customers.
- The companies must try to reduce the time gap between the production of goods and sales of goods by improving their process of manufacturing.
- Do not overstock the inventory in the warehouse .The finished goods must be sold as early as possible .
- Obtaining raw materials and goods required for production from the suppliers with better credit terms can also help in reducing the working capital cycle.
Thus, the working capital cycle helps to measure how fast a business can convert its net current assets into cash which can enable a business to manage its cash flow, inventory and efficiency in a better way.