5.4 Working Capital Cycle
This represents the time frame from the conversion of inventory to the collection of cash from debtors. The working capital cycle differs from entity to entity, and is influenced by various factors including the nature of the inventory that the business holds. Retail, manufacturing and services entities have different working capital cycles due to the fact that each business has a different structure. For example, the working capital structure of MTN will be different from that of Standard Bank or Clicks.
The calculation of the working capital cycle is done by taking into account the various components that make up working capital such as raw materials inventory, finished goods inventory, work in process inventory, debtors and creditors. The difference between the total number of days in receivables and inventory and the payments to creditors.
Working Capital Cycle
Working Capital Cycle (WCC) is the time it takes to convert net current assets and current liabilities (e.g. bought stock) into cash. Long cycles means tying up capital for a longer time without earning a return. Short cycles allow your business to free up cash faster and be more agile.
If, for example, the cycle takes 190 days and the creditors days is 90 days, then financing will be needed for 100 days. The days invested in each component can be estimated using the following accounting ratios:
- Raw material inventory days raw material inventorypurchases x 365
- Work in progress inventory days work in progress inventorycost of sales x 365
- Finished goods inventory days finished goods inventorycost of sales x 365
- Debtors days debtorssales x 365
- Creditors days creditorspurchases x 365
Management’s goal should be to shorten the working capital cycle by as much as possible without affecting the efficiency of operations. This would improve the return on assets by reducing the investment in working capital and related financing costs. The cycle can be shortened by reducing the time to taken to convert raw materials into finished goods, sell finished goods, recover cash from debtors, reducing the time between receiving raw materials and transferring such raw materials to production and lengthening the time take to pay creditors.
The cash-to-cash cycle (CCC) is the time (in days) that the company takes to convert inventory to cash and some companies refer to the days outstanding in net working capital as follows:
CCC = DIO (Days Inventory Outstanding) + DSO (Days Sales Outstanding) –
DPO (Days Payable Outstanding)
= Inventory Days + Debtors Days – Creditors Days
