The working capital cycle (WCC) is the time it takes for a business to convert its current assets and liabilities into cash. It’s also known as the cash conversion cycle. In simple terms, the working capital cycle or operating cycle refers to the length of time required to convert non-cash current assets like raw materials, work-in-process, finished goods, and receivables into cash.
Understanding the WCC Process
At each stage of the operating cycle, a manufacturing unit needs to hold stock for a specific period before dispatching the final products to customers:
- Raw Materials: Held until used in production.
- Work-in-Process: Held during production.
- Finished Goods: Held until sold.
- Receivables: Dependent on the credit period extended to customers.
If a business holds current assets (stocks and receivables) beyond the required period, it may face financial implications, such as higher interest payable on current liabilities due to delayed cash conversion.
Formula for Calculating WCC
The WCC is calculated using the formula:
WCC = Inventory Days + Receivable Days – Payable Days
Example Calculation
A manufacturing unit has:
- Payable Days: 90 days
- Inventory Days: 60 days
- Receivable Days: 20 days
To calculate the working capital cycle:
WCC = 60 + 20 – 90
WCC = 10 days
This means it takes the business 10 days to convert its current assets into cash after accounting for payment obligations.
Steps in the WCC
- Materials Procurement: The Company receives the materials needed for production without initially dispensing cash (purchased on credit under accounts payable). Payment is due in 90 days.
- Production and Sales: Inventory is sold within 60 days.
- Customer Payment: Payment from customers is received within 20 days.
Method for Calculating Holding Periods
To calculate the length of the holding period for inventory days, receivable days, and payable days, specific methods should be explored.
Read: METHOD OF CALCULATING LENGTH OF HOLDING PERIOD FOR STOCKS AND RECEIVABLES
Types of Working Capital Cycles
Positive Working Capital Cycle
A positive WCC indicates that a company takes longer to convert its current assets into cash than it takes to pay off its current liabilities. This is considered a normal situation for most businesses as it implies that the company needs time to collect payments from customers before paying suppliers.
Negative Working Capital Cycle
A negative WCC can indicate efficiency in businesses with low inventory and accounts receivable. However, it may also signal financial distress if the company lacks sufficient cash to meet its current liabilities.
Short Working Capital Cycle
A shorter WCC is beneficial as it allows the company to free up cash that would otherwise be tied up in the cycle. On the other hand, a long WCC means capital remains locked without generating returns, potentially leading to cash flow problems. Ensuring the availability of sufficient capital during this cycle is crucial to avoid falling into debt or operational issues.
