Sources of Working Capital & its Estimation Operating Cycle

Working capital is the operating capital of a business that is used in its day-to-day operations, calculated as the current assets minus the current liabilities. The positive working capital commonly indicates that a company can pay off its short-term liabilities almost immediately.

Source of working capital:

Sources of working capital are Share Capital, retained profits, debentures, long-term loans, and provisions for depreciation, which are usually considered long-term working capital sources. The sources of short-term working capital include tax provisions, public deposits, Commercial papers, Cash Credit limits availed from the banks, and others. Trade Credit is another important source of short-term working capital involving delayed payment to suppliers which effectively provides an interest-free loan.

Working capital operating cycle:

The working capital operating cycle formula is used to calculate the length of a business’s working capital cycle.  It is also known as the cash operating cycle or the cash conversion cycle). It is also important to take into account of the working capital payable days (creditor’s days) i.e. the number of days between paying suppliers and receiving cash from sales. It means the operating cycle of working capital is the total number of days that a business takes to buy inventory and convert it to finished goods, sell it off, and then collect the proceedings from the sale.

Thus,

Cash operating cycle = Inventory days + Receivables days – Payables days.

The working capital cycle formula may vary depending on the type of business.

In the manufacturing sector inventory days have three components:

(i) Raw materials days

(ii) work-in-progress days (the length of the production process), and

(iii) Finished goods days.

1. The Inventory Period is calculated as follows:

Inventory Period = 365 / Inventory Turnover

Where the formula for Inventory Turnover is:

Inventory Turnover = Cost of Goods Sold (COGS) / Average Inventory

Where,

COGS = the starting inventory + purchases – ending inventory.

Average inventory = (Beginning inventory + Ending inventory) / 2

• The Accounts Receivable Period is calculated as follows:

Accounts Receivable Period = 365 / Receivables Turnover

The formula for Receivables Turnover is:

Receivables Turnover = Credit Sales / Average Accounts Receivable

Where,

Credit sales or debtors days are calculated as when an invoice is issued and when the customer’s payment is received, excluding cash sales.

Formula for Credit sales:

Credit sales= Closing debtors+ Receipts -Opening debtors

Average accounts receivable:

Average accounts receivable = Sum of starting receivable and ending accounts receivable over a period (such as monthly or quarterly), divided by 2

The period is usually monthly, quarterly, or annually.

Therefore, the detailed formula for OC is:

Operating Cycle= 365÷ (Cost of goods sold/Average Inventory) + 365÷ (Credit sales/ Average Accounts receivable)

Conclusion:

The operating cycle of working capital is calculated by adding the Days Inventory Outstanding (DIO) to the Days Sales Outstanding (DSO), i.e. [Operating cycle of working capital=DIO+DSO]. The cash conversion cycle (CCC) is similar but includes a payable variable. That equation is DIO + DSO – DPO = CCC.