A working capital cycle (WCC) may sound like financial jargon, but it’s an important concept for business owners to understand. What entrepreneur wouldn’t want to know how fast their company can turn a profit?
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. To understand net working capital, you should know what your current assets and current liabilities are.
Current assets can be converted to cash in a short-period. In financial parlance, “current” or “short-term” typically refers to one year. A business’s current assets might include inventory, accounts receivables, prepaid expenses, or short-term investments. They don’t include long-term assets, such as real estate or equipment. Your firm’s Current liabilities are its debts and obligations within the same period. These might be bills to vendors, payroll, or serving loans.
Working capital is your current assets net of current liabilities. In other words, working capital is the assets you have after paying your bills, at least in the short-term. Essentially, the working capital cycle begins when assets are obtained to start the operating cycle and ends when the sale of a product or service is converted to cash.
Ultimately, the working capital ratio that you have will determine if you can afford short-term expenses, so it’s imperative that you monitor your business’s finances. One way to do this is to keep a balance sheet, which is a statement of your business’s assets, capital, and liabilities. Referring to your balance sheet frequently will enable you to review how much positive working capital you have, so that you can adjust payment cycles or other factors
What Affects the Cycle?
The stages of a working capital cycle will vary depending on your business’s industry and how you operate, but the key elements will be the same. For accounting purposes, the working capital cycle is measured by how long inventory takes to move, and the time it takes to receive cash payment from the sale, subtracted by how long your business has to pay its bills.
For instance, the working capital cycle for a retail company might involve purchasing raw materials on credit to begin the cycle, selling the product over several weeks, and collecting cash from credit card sales a month later. Let’s say it takes the business 90 days to turn inventory into cash, and the bill for inventory is due in 60 days. Therefore, the business’s working capital cycle is 30 days, which is how long the company will be short on cash.
Ideally, owners will want a negative working capital cycle, in which they receive payment for goods before their own bills are due. This can be accomplished by revising various stages of the cycle, such as moving inventory faster, or asking customers to pay sooner. You could also lengthen your accounts payable or credit terms, for example, by asking vendors to give you more time to pay your bill.
Financing Growth and Working Capital
Businesses with normal/positive cycles often require financing to cover the period of time before they receive payment from customers and clients. This is especially true for rapidly growing companies. A common warning axiom regarding growth and working capital is to be careful not to “grow the company out of money.”
To deal with this potential problem, companies often arrange to have financing provided by a bank or other financial institution. Banks will often lend money against inventory and will also finance accounts receivable.
For example, if a bank believes the company is capable of liquidating its inventory at 70%, it may be willing to provide a loan equal to 50% of the value of the inventory. (The 20% difference between 70% and 50% gives the bank a buffer, or financing cushion, in case the inventory has to be liquidated).
Additionally, if a company sells products to businesses that have high creditworthiness, the bank may finance those receivables (called “factoring”) by providing early payment of a percentage of the total revenue. By combining one or both of the above financing solutions, a company can successfully bridge the gap of time required for it to conclude its working capital cycle. Small business owners who fall short might turn to financing options, such as a revolving credit line, cash advance, or business loan to bridge these gaps in cash flow.
Ultimately, you should try to shorten the working capital cycle. The faster your business converts assets to cash, the sooner that cash is available for use to run and grow your operations.