The working capital cycle
Nature and purpose
Working capital is the difference between current assets and current liabilities
An asset expected to be realised, consumed or sold within the normal operating cycle of the business is referred to as a current asset
A liability is treated as a current liability if it is due to be settled within the normal operating cycle of the business
Working capital is the total amount of capital tied up in current assets and current liability
Normally includes inventories, trade receivables, cash and cash equivalents less trade payables
Working capital = inventory + trade receivables + cash and cash equivalents - trade payables
Working capital can be regarded as the lifeblood of an organisation
An organisation cannot survive without working capital funds
The finance needed to fund a firm's required level of working capital can be either short term or long term
Permanent working capital: the overall level remains fixed and should be financed by long term sources of finance
Temporary working capital: fluctuates day to day above this level of permanent working capital, it should be financed by short term sources of finance
The permanent working capital is the minimum level of working capital required to continue uninterrupted day to day business activties
Temporary working capital is the additional financial requirement that arises out of events such as seasonal demand
WCC refers to the time taken by an organisation to convert its net current assets into cash
The length of the cycle depends on
The balancing act between liquidity and profitability
Efficiency of management
Terms of trade
The nature of the industry
Nature of the indsutry
The manufacturing sector has a long cycle with significant current assets, it tends to reduce inventory holding through JIT systems. Suppliers deliver precise quantities, significantly reducing the manufacturer's holdings of raw materials and components
The distributive sector tend to have a shorter cycle with few credit customers, high finished goods inventory and long payment periods. Retails tend to purchase from manufacturers and wholesalers on credit
The service sector does not hold any finished goods. Current liabilities will include less significant suppliers. Trade received could include amounts owed from customers
Calculating WCC
WCC is the time between buying the goods to manufacture products and generation of cash receipts from selling the products
WCC = inventory holding period + trade receivables collection period - trade payables payment period
Inventory holding period
The average number of days taken to process or sell inventory
Raw material holding period = inventory of raw material / cost of RM consumed per day
WIP holding period = WIP inventory / cost of production per day
Finished goods storage period = inventory of FG / cost of goods sold per day
Trade receivables collection period
The average number of days taken to receive payment from customers for goods or services sold to them on credit
Trade receivables x 365 / credit sales (or revenue)
Trade payables payment period
The average number of days taken to make payment to suppliers for goods purchased on credit
Trade payables * 365 / credit purchases (or cost of goods sold)
Working capital management
Every company should have adequate or optimum working capital to run its operations efficiently and effectively but without holding too much working capital
Holding high levels of working company means the company has idle funds with unnecessary cost implications (overcapitalisation)
A low level of working capital can result in a situation where the company is not able to meet its day to day demands and may lead to insolvency
Overtrading is usually associated with a rapid increase in revenue that is not supported by sufficient working capital
The signs of overtrading are
A rapid increase in revenue and the volume of current assets
Most of the increase in assets being financed by credit
A dramatic drop in liquidity ratios
Companies need working capital to keep the business running
The main objective of WC management is get the balance of current assets and current liabilities right
An aggressive approach that chooses to have a lower level of WC will result in higher profitability and higher risk while a conservative approach that chooses to have higher level of WC will result in lower profitability, lower risk, will require more cash and will tie up cash