From small businesses to mega enterprises, the working capital cycle is a crucial metric for every business to assess its long-term financial health and ensure cash flow adequacy for its short-term commitments. Managing the working capital cycle effectively will optimise an organisation’s operating cycle, reduce the cost of working capital, and maximise return on its investments.
The working capital cycle is the time it takes for a business to convert its net current assets like inventory into cash. For businesses, understanding their working capital cycle means knowing exactly how long their funds are tied up and how soon they will have access to operational needs or business growth funds. The working capital cycle is usually expressed in the number of days, and the shorter the working capital cycle, the more efficient the business is at managing its finances. Long working capital cycles mean tied-up capital with no return for a longer time.
The working capital cycle can be calculated using the below formula:
Working Capital Cycle = Inventory Days + Receivable Days – Payable Days
If every business transaction for an organisation could occur on the same day, it would make it super simple to understand its financial position at any point in time. However, this isn’t the case, there’s always a time lag between paying for an asset, selling inventory, and receiving payment from customers, which could impact cash flow. A business must manage its working capital cycle to improve the short-term liquidity and efficiency of its business.
A business relies on a free cash flow, i.e. enough cash-in-hand to meet its operational costs, such as paying staff, buying raw material and paying other bills, etc. Understanding the working capital cycle lets organisations predict how quickly they’ll receive funds into their business to plan and budget properly.
Reducing Inventory and Improving Inventory turnover
For a business that carries large inventory, a well-managed inventory might be the most powerful way to leverage its working capital cycle. An improved working capital cycle could be achieved by reducing slow-moving inventory, avoiding stockpiling and maximising the inventory turnover cycles. Although inventory is a crucial asset for the overall working capital, less inventory on the shelves means more freed-up cash. For optimising the inventory, a business requires a robust inventory management process and period analysis of inventory performance metrics.
Shifting to Digital Payables and Receivables
The shift from paper to electronic transactions has transformed the payment process. Applying automation to accounts receivables can help deliver invoices electronically and shorten the receivables period. Electronic receivables would reduce manual processing, lost invoices, and errors and ensure proper management with timely reminders for any inefficiencies.
Electronic payments are a norm today, and optimising receivables and payables with automated processes is crucial for accelerated cash conversion cycles. Electronic payment and automated payments processes can help businesses to reduce costs through employing better payment terms, savings on rebate structures, etc.
Increase Payable Days
Most suppliers would extend credit to their buyers for a specific period before they need to pay them. For instance, a supplier might need payment within 30 days. A buyer should try to negotiate for a longer payment term with its suppliers. A longer payable period allows the buyer to use the cash for other business priorities.
Working Capital Financing
Finally, some specialist financial services can help a business with instant cash supporting its working capital cycle.
Accounts receivable financing and invoice factoring can shorten the supplier’s receivable days by offering cash advances based on the outstanding customer invoices. Credit lines are a short-term solution for freeing up cash within a business and are best used to shorten inventory days.
Some of these financing options could involve higher interest and fees, so a business needs to balance the cost against its need for instant operational funds.