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Working capital cycle
The working capital cycle is a measure of how quickly a business can turn its current assets
into cash. Understanding how it works can help small business owners like you manage their
company’s cash flow, improve efficiency, and make money faster.
Length of Working Capital Cycle
The Working Capital Cycle for a business is the length of time it takes to convert the total net
working capital (current assets less current liabilities) into cash. Businesses typically try to
manage this cycle by selling inventory quickly, collecting revenue from customers quickly,
and paying bills slowly to optimize cash flow.
Steps in the Working Capital Cycle
Step 1: Inventory days: The first thing you need to do is get to know your inventory.
Inventory is your stock, goods and other contents of your business. Your inventory days refer
to the time it takes, on average, to sell your inventory.
Step 2: Receivable days: Now that you’ve produced and sold your stock, you need to be
paid. Your clients, also referred to as your debtors, take 21 days to pay you for the order of
straw that you’ve invoiced. In other words, you’re working with 21 receivable days.
Step 3: Payable days: Next, we need to look at your payment practices. How long does it
take you to pay your suppliers (also referred to as your creditors) for the raw materials used
to make the metal straws? In this example, we’ll say that it takes 90 days for you to pay your
suppliers. So, you’re working with 90 payable days.
Step 4: Working capital cycle: Now that we have all the parts, we can work out your
working capital cycle. Let’s put them into the formula: 80 inventory days + 21 receivable
days – 90 payable days = a working capital cycle totalling 11 days
Working Capital Cycle Formula
Working Capital Cycle Sample Calculation
Now that we know the steps in the cycle and the formula, let’s calculate an example based on
the above information.
Inventory days = 85
Receivable days = 20
Payable days = 90
Working Capital Cycle = 85 + 20 – 90 = 15
This means the company is only out of pocket cash for 15 days before receiving full payment.
Working capital cycle and terms of trade
Challenges and Opportunities in International Trade
In international trade there are
additional challenges that arise for the
UK business such as culture,
distance, currency and banking
settlements. These challenges also
present opportunities to build lasting
and successful relationship s, whilst
allowing the business to trade
profitability.
The opportunity for the UK business is to build strong and lasting relationships with overseas
suppliers and customers, with an understanding from all parties. The importance of
relationships in business should never be underestimated; it should be viewed as a partnership
with both parties benefiting from the relationship.
Clear processes can exist for terms of trade covering payment, shipment, insurance and
quality control. Over time these can be modified as trust increases – in this way the initial
challenges faced by businesses can be turned into an opportunity which benefits both the
working capital cycle and ability of the business to trade profitability.
Working Capital Policy on the level of investment in current assets
Working capital policies involve determining the sources of finance. It also determines the allocation
of these finances towards current assets and liabilities. Broadly, three strategies can help optimise
working capital financing for a business, namely, hedging, aggressive, and conservative, as per the
risk levels involved.
Aggressive versus conservative approach
A firm choosing to have a lower level of working capital (including cash) than rivals is said to have an
‘aggressive’ approach, whereas a firm with a higher level of working capital (including high cash
balances) has a ‘conservative’ approach.
An aggressive approach will result in higher profitability and higher risk, while a conservative
approach will result in lower profitability and lower risk.
Over-capitalisation and working capital
If there are excessive inventories, accounts receivable and cash, and very few accounts payable, there
will be an over-investment by the company in current assets. Working capital will be excessive and
the company will be overcapitalised.
Overtrading
Cash flow is the lifeblood of the thriving business. Effective and efficient management of the working
capital investment is essential to maintaining control of business cash flow. Management must have
full awareness of the profitability versus liquidity trade-off.
For example, healthy trading growth typically produces:
• increased profitability
• the need to increase investment in non-current assets and working capital.
In contrast to over-capitalisation, if the business does not have access to sufficient capital to fund the
increase, it is said to be ‘overtrading’. This can cause serious trouble for the business as it is unable to
pay its business creditors.
It should look out for the following:
• A rapid increase in revenue
• An increase in the values of the working capital days, particularly receivables and payables
• Most of the increase in assets being financed by credit
• A dramatic drop in the liquidity ratios (see next section) Working capital investment
Strategies for funding working capital
In the same way as for long-term investments, a firm must make a decision about what source of
finance is best used for the funding of working capital requirements.
The decision about whether to choose short- or long-term options depends upon a number of
factors:
• the extent to which current assets are permanent or fluctuating
• the costs and risks of short-term finance
• the attitude of management to risk
Permanent or fluctuating current assets
In most businesses a proportion of the current assets are fixed over time, i.e. ‘permanent’. For
example:
• buffer inventory,
• receivables during the credit period,
• minimum cash balances
The choice of how to finance the permanent current assets is a matter for managerial judgement, but
includes an analysis of the cost and risks of short term finance.
The cost of short-term finance
Short-term finance is usually cheaper than long-term finance. This is largely due to the risks taken by
creditors. For example, if a bank were considering two loan applications, one for one year and the
other for 20 years, all other things being equal it would demand a higher interest rate on the 20-year
loan. This is because it feels more exposed to risk on long-term loans, as more could go wrong with
the borrower over a period of twenty years than a period of one year (although it should be noted
that occasionally this situation is reversed, with rates of return being higher on short-term finance).
Short-term finance also tends to be more flexible. For example, if funds are raised on overdraft and
used to finance a fluctuating investment in current assets, they can be paid off when not required and
interest saved.
On the other hand, if funds were borrowed for the long term, early repayment may not be possible, or,
if allowed, early repayment penalties may be experienced. The flexibility of short-term finance may,
therefore, reduce its overall cost.
Short-term finance includes items such as trade payables, which are normally regarded as low cost
funds, whereas long-term finance will include debt and equity. Equity finance is particularly
expensive, its required returns being high, and dividends are non-tax deductible.
The risks of short-term finance
Short-term financing has already been established as generally ‘the cheaper option’. However, the
price paid for reduced cost is increased risk for the borrower.
There may be:
Renewal problems – short-term finance may need to be continually renegotiated as various facilities
expire and renewal may not always be guaranteed.
Unstable interest rates – if the company constantly has to renew its funding arrangements, it will be
at the mercy of fluctuations in short-term interest rates.

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Manage cash flow faster with the working capital cycle

  • 1. Working capital cycle The working capital cycle is a measure of how quickly a business can turn its current assets into cash. Understanding how it works can help small business owners like you manage their company’s cash flow, improve efficiency, and make money faster. Length of Working Capital Cycle The Working Capital Cycle for a business is the length of time it takes to convert the total net working capital (current assets less current liabilities) into cash. Businesses typically try to manage this cycle by selling inventory quickly, collecting revenue from customers quickly, and paying bills slowly to optimize cash flow. Steps in the Working Capital Cycle Step 1: Inventory days: The first thing you need to do is get to know your inventory. Inventory is your stock, goods and other contents of your business. Your inventory days refer to the time it takes, on average, to sell your inventory.
  • 2. Step 2: Receivable days: Now that you’ve produced and sold your stock, you need to be paid. Your clients, also referred to as your debtors, take 21 days to pay you for the order of straw that you’ve invoiced. In other words, you’re working with 21 receivable days. Step 3: Payable days: Next, we need to look at your payment practices. How long does it take you to pay your suppliers (also referred to as your creditors) for the raw materials used to make the metal straws? In this example, we’ll say that it takes 90 days for you to pay your suppliers. So, you’re working with 90 payable days. Step 4: Working capital cycle: Now that we have all the parts, we can work out your working capital cycle. Let’s put them into the formula: 80 inventory days + 21 receivable days – 90 payable days = a working capital cycle totalling 11 days Working Capital Cycle Formula Working Capital Cycle Sample Calculation Now that we know the steps in the cycle and the formula, let’s calculate an example based on the above information. Inventory days = 85 Receivable days = 20 Payable days = 90 Working Capital Cycle = 85 + 20 – 90 = 15 This means the company is only out of pocket cash for 15 days before receiving full payment. Working capital cycle and terms of trade Challenges and Opportunities in International Trade
  • 3. In international trade there are additional challenges that arise for the UK business such as culture, distance, currency and banking settlements. These challenges also present opportunities to build lasting and successful relationship s, whilst allowing the business to trade profitability. The opportunity for the UK business is to build strong and lasting relationships with overseas suppliers and customers, with an understanding from all parties. The importance of relationships in business should never be underestimated; it should be viewed as a partnership with both parties benefiting from the relationship. Clear processes can exist for terms of trade covering payment, shipment, insurance and quality control. Over time these can be modified as trust increases – in this way the initial challenges faced by businesses can be turned into an opportunity which benefits both the working capital cycle and ability of the business to trade profitability. Working Capital Policy on the level of investment in current assets Working capital policies involve determining the sources of finance. It also determines the allocation of these finances towards current assets and liabilities. Broadly, three strategies can help optimise working capital financing for a business, namely, hedging, aggressive, and conservative, as per the risk levels involved. Aggressive versus conservative approach
  • 4. A firm choosing to have a lower level of working capital (including cash) than rivals is said to have an ‘aggressive’ approach, whereas a firm with a higher level of working capital (including high cash balances) has a ‘conservative’ approach. An aggressive approach will result in higher profitability and higher risk, while a conservative approach will result in lower profitability and lower risk. Over-capitalisation and working capital If there are excessive inventories, accounts receivable and cash, and very few accounts payable, there will be an over-investment by the company in current assets. Working capital will be excessive and the company will be overcapitalised. Overtrading Cash flow is the lifeblood of the thriving business. Effective and efficient management of the working capital investment is essential to maintaining control of business cash flow. Management must have full awareness of the profitability versus liquidity trade-off. For example, healthy trading growth typically produces: • increased profitability • the need to increase investment in non-current assets and working capital. In contrast to over-capitalisation, if the business does not have access to sufficient capital to fund the increase, it is said to be ‘overtrading’. This can cause serious trouble for the business as it is unable to pay its business creditors. It should look out for the following: • A rapid increase in revenue • An increase in the values of the working capital days, particularly receivables and payables • Most of the increase in assets being financed by credit • A dramatic drop in the liquidity ratios (see next section) Working capital investment Strategies for funding working capital In the same way as for long-term investments, a firm must make a decision about what source of finance is best used for the funding of working capital requirements.
  • 5. The decision about whether to choose short- or long-term options depends upon a number of factors: • the extent to which current assets are permanent or fluctuating • the costs and risks of short-term finance • the attitude of management to risk Permanent or fluctuating current assets In most businesses a proportion of the current assets are fixed over time, i.e. ‘permanent’. For example: • buffer inventory, • receivables during the credit period, • minimum cash balances The choice of how to finance the permanent current assets is a matter for managerial judgement, but includes an analysis of the cost and risks of short term finance. The cost of short-term finance Short-term finance is usually cheaper than long-term finance. This is largely due to the risks taken by creditors. For example, if a bank were considering two loan applications, one for one year and the other for 20 years, all other things being equal it would demand a higher interest rate on the 20-year loan. This is because it feels more exposed to risk on long-term loans, as more could go wrong with the borrower over a period of twenty years than a period of one year (although it should be noted
  • 6. that occasionally this situation is reversed, with rates of return being higher on short-term finance). Short-term finance also tends to be more flexible. For example, if funds are raised on overdraft and used to finance a fluctuating investment in current assets, they can be paid off when not required and interest saved. On the other hand, if funds were borrowed for the long term, early repayment may not be possible, or, if allowed, early repayment penalties may be experienced. The flexibility of short-term finance may, therefore, reduce its overall cost. Short-term finance includes items such as trade payables, which are normally regarded as low cost funds, whereas long-term finance will include debt and equity. Equity finance is particularly expensive, its required returns being high, and dividends are non-tax deductible. The risks of short-term finance Short-term financing has already been established as generally ‘the cheaper option’. However, the price paid for reduced cost is increased risk for the borrower. There may be: Renewal problems – short-term finance may need to be continually renegotiated as various facilities expire and renewal may not always be guaranteed. Unstable interest rates – if the company constantly has to renew its funding arrangements, it will be at the mercy of fluctuations in short-term interest rates.