How to Use the Working Capital Cycle for Better Financial Management

The working capital cycle is an essential financial indicator of your business’s financial efficiency. This measures and tracks your business’s time to convert assets and liabilities into cash. In simple words, this cycle dedicates how long it takes for you to arrange finds for your business. 

Knowing this is important as liquidity is a crucial parameter to carry out the regular operation of your business. Gaining more information on the capital cycle can help you maintain stability during a challenging economic environment.  

Understanding Important Components of Working Capital Cycle

Successful business management includes comparing all the current assets against current liabilities. However, there are a few important pillars to keep in mind for better management of working capital:

Billing

This indicates the time taken by the buyer to pay the seller for goods or services. The billing process includes:

• Gathering data of the buyer or seller
• Creating the invoices
• Sending invoices to the parties 
• Getting confirmation and tracking payments
• Collecting payments 
• Adding records into the accounting software

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Inventory

This indicates the overall time a company takes to convert sales into inventory. This is an important component indicating your business’s inventory management and how well you manage the stock levels. All the money spent on buying inventory gets deducted from the working capital. 

Receivables

Managing the receivables is important in terms of collecting the money owed to a company. Receivables are the amount owed to your company for purchasing goods or services indicating the rights to collect in future.

Cash

You can ensure a constant and steady cash flow to the business by ensuring the timely management of payables and receivables. That can help better optimise operation efficiency, which helps in making a strategy to balance the requirements.

Operating Cycle in Working Capital

The time required to convert the current assets to cash is calculated by adding different operating cycle days. The working capital days indicate the time period starting from the day you pay for inventory to the payment you receive by selling.

These are the cycles involved in the procedure:

• Step 1: This cycle starts with cash in hand, but later, gets tied up in the payment of raw materials. It is known as inventory days, as your cash is used to acquire inventory for the business.

• Step 2: The account receivable cycle represents the time period required to collect the payment from the customers after selling them goods or services. 

• Step 3: The account payable cycle represents the time period when your business’s cash is tied up in paying the suppliers for raw materials.

Knowing all the cycles and the days each takes, you can use the working capital cycle equation. 

Also Read: What is Working Capital Demand Loan (WCDL)? 

How to Calculate It

Using the formula for the working capital cycle, you can calculate the capital cycle:

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

What Strategies to Implement

To increase your business’s operational efficiency, you can implement various strategies such as:

• Having good credit terms

This strategy can increase payable days by maintaining a good supplier relationship. You can negotiate to keep the cash for a longer period and utilise it in various other areas of your business.

• Accelerating cash collection

You can reduce the receivable days with proper practice of maintaining invoices. You can also offer discounts for previous payments.

• Speeding up sales

By improving demand forecasting and applying lean inventory techniques, you can reduce and decrease the length of inventory days. 

You can also use certain software and tools to manage the capital cycle. Using inventory management software will help you to track stocks and optimise reorder points. Having a good invoicing system can help you in billing automation, eventually speeding up the payment cycle. 

Using a financial planning tool can provide you with information on ongoing cash flow trends. This will help in better financial strategizing and business forecasting.

By using these techniques, you can effectively optimise your capital cycle to create sustainable financial health in the long term. While it is necessary to maintain the capital cycle, sometimes unforeseen expenditures can cause financial scarcity. 

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FAQs on Working Capital Cycle

What is a good working capital cycle length?

A short capital cycle is desirable, though having a long cycle is not bad. However, it depends on the nature of the business.

How does the working capital cycle affect a company’s cash flow?

The cycle represents the availability of liquidity and, hence company’s cash flow. The shorter it is, the better the business can run. 

Can a negative working capital cycle be beneficial?

Yes, a negative capital cycle represents the availability of liquidity to carry out day-to-day business expenses, benefiting the company.

How does the working capital cycle impact financial statements?

A negative working capital cycle represents a financially healthy cash flow, maintaining a positive impact on the financial statement.