Working Capital Cycle

Working Capital Cycle

Working capital is vital to a business. They have to have funds available to pay their day to day bills, wages and so on. The working capital is made up of the current assets net of the current liabilities. It is very important to a company to manage its working capital carefully. This is particularly true where there is a substantial time lag between making the product and receiving the money for it. In this situation the company has paid out all the costs associated with making the product (labour, raw materials and so on) but not yet got any money for it. They must therefore ensure they have enough cash to do this. The way working capital moves around the business is modelled by the working capital cycle. This shows the cash coming into the business, what happens to it while the business has it and then where it goes. A simple working capital cycle may look something like:- Between each stage of this working capital cycle there is a time delay. For some businesses this will be very long where it takes them a long time to make and sell the product. They will need a substantial amount of working capital to survive. Others though may receive their cash very quickly after paying out for raw materials etc... (perhaps even before they've paid their bills?) - they will need less working capital. The above network diagram may offer a clear picture of a complete working capital i.e. it is a cash to cash phenomenon. In the diagram, Raw material stock refers to material only. In WIP, components involve are raw materials, wages and overheads- more specifically manufacturing overhead. Finished stock consists component of material, wages, and selling and distribution overheads. Debtors include materials, wages, overheads and profit. Creditors involve for the components of raw materials etc. while estimating the working capital requirement. The operating cycle consists of the following events which continues throughout the life of a firm remaining engaged in commercial activities: I. Conversion of cash into raw materials. II. Conversion of raw materials in WIP III. Conversion of WIP into finished goods. IV. Conversion of finished goods into account receivable and Debtors through sales. V. Conversion of Accounts receivable into cash. Calculation Of Working Capital Cycle: So far we have discussed about nature and scope of working capital cycle. The finance manager must be prepared to know the exact period of operating cycle as because he has to plan for ensuring liquidity and profitability of the concern. Component wise working capital cycle-period can be ascertained as below: In the form of a simple equation, working capital cycle can be represented as below: WWC = R + W + F + D + B – C Where, WWC= Working Capital Cycle R= Raw Materials W= Work in progress F= Finished StockB=Cash at Bank D= Debtors and Receivable collection periodC= Credit period available