Working capital is a common measure of a business’ overall health – it’s an indicator of whether a company is able to pay off its short-term liabilities or not. Here we provide information about the working capital cycle and how to manage elements of the cycle to improve working capital within a business.
Working capital is a measure of a business’ liquidity and short term financial health. It is an indicator of how easily a business is able to meet its short term financial obligations, such as repayment of debt, as well as cover expenses relating to day-to-day operational activities.
At a high level, working capital is calculated as: Current Assets – Current Liabilities.
The result shows the available working capital a business has in order to meet its short term financial obligations. If the result is positive this indicates the amount of short term funds from current assets are more than adequate to pay for current liabilities. If the result is substantially negative then the business may be in danger of not having sufficient funds to pay liabilities when they become due, and is at risk of becoming insolvent.
The working capital cycle is the amount of time it takes to turn current assets and current liabilities into cash. It measures the time between paying for goods supplied to you and the final receipt of cash to you from the sale.
Ideally you'd want to keep the working capital cycle as short as possible as it increases the effectiveness of working capital. The longer the cycle, the longer a business is tying up capital without getting any returns.
The working capital cycle is important as a business with a short cycle usually has healthy cash flow, whereas a business with a long cycle is likely to have cash flow difficulties.
Understanding the elements of the working capital cycle within a business is therefore important in order to minimise this length and enable effective cash flow.
The working capital cycle is calculated by taking the difference between the average number of days a business takes to pay suppliers and the average number of days a business takes to receive payment from their customers.
The working capital cycle can be broken down into segments which can be seen in the following example. If a business is able to identify the time taken in each of these stages then actions can be identified to try to reduce any inefficient stages of the process.
A business may use the above information to highlight inefficiencies such as the 10 day delay between purchasing the raw materials and producing the product. Investigating the cause of this may lead to an improved cycle. Additionally, if this was a cash sale then the cycle would be 15 days, which would reduce the amount of time capital is tied up by 10 days.
Stock control involves creating a balance between the need to maintain stock levels in order to fulfil customer orders and the cost of this. Stock control can involve a number of activities that may enable a business to manage stock more effectively.
The consequences of poor credit control can include:
If a business sells goods or services on credit, it is important to have good credit control processes in place. There are a number of steps that can be taken to improve credit control, including reviewing the following:
Current assets are amounts that a business can reasonably expect to convert to cash within one year. Examples of currents assets include:
Current liabilities are a business’ debts or obligations that must be paid within one year. Essentially, these are amounts due to suppliers and other creditors, including:
Current liabilities are generally paid by liquidating current assets, for example by receiving payments from customers, but may also be settled through replacement by other liabilities such as short term loans.
Pressure on cash flow is a key sign of a working capital cycle that requires improvement. Any business needs cash to operate successfully so if the working capital cycle is impacting on this then improvement is required.
Even if a business is not having cash flow problems there may still be room for improvement within the working capital cycle that may enable additional growth or investment.
If you see an unexplained reduction in cash flow then it may be worthwhile reviewing the cycle to identify any inefficiencies that may have developed and put in place an action plan to improve this. Looking at this at regular intervals should help you make the most your working capital and alert you to trouble well before it strikes.
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