What is an operating cycle How is it important for the management of working capital?

The length of time to convert net working capital into cash

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Steps in the Working Capital Cycle
Working Capital Cycle Formula
Working Capital Cycle Sample Calculation
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Positive vs. Negative Working Capital Cycle
Financing Growth and Working Capital
Working Capital Cycle in Financial Modeling
Additional Resources

The Working Capital Cycle for a business is the length of time it takes to convert the total net working capital (current assets less current liabilities) into cash. Businesses typically try to manage this cycle by selling inventory quickly, collecting revenue from customers quickly, and paying bills slowly to optimize cash flow.

Steps in the Working Capital Cycle

For most companies, the working capital cycle works as follows:

The company purchases, on credit, materials to manufacture a product. For example, they have 90 days to pay for the raw materials (payable days).
The company sells its inventory in 85 days, on average (inventory days).
The company receives payment from customers for the products sold in 20 days, on average (receivable days).

In the first step of the process, the company gets the materials it needs to produce inventory but doesn’t initially dispense any cash (purchased on credit under accounts payable). In 90 days’ time, it will have to pay for those materials.

Eighty-five (85) days after buying the materials, the finished goods are made and sold, but the company doesn’t receive cash for them immediately, as they are sold on credit (recorded under accounts receivable). Twenty (20) days after selling the goods, the company receives cash, and the working capital cycle is complete.

Working Capital Cycle Formula

Based on the above steps, we can see that the working capital cycle formula is:

Working Capital Cycle Sample Calculation

Now that we know the steps in the cycle and the formula, let’s calculate an example based on the above information.

Inventory days = 85
Receivable days = 20
Payable days = 90

Working Capital Cycle = 85 + 20 – 90 = 15

This means the company is only out of pocket cash for 15 days before receiving full payment.

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Positive vs. Negative Working Capital Cycle

In the above example, we saw a business with a positive, or normal, cycle of working capital. Sometimes, however, businesses enjoy a negative working capital cycle where they collect money faster than they pay off bills.

Sticking with the above example, imagine now that the company decides to become a “cash only” business with its customers. By only accepting cash (no credit cards or payment terms), its accounts receivable days become 0.

Let’s use the same formula again and calculate their new cycle time.

Inventory days = 85
Receivable days = 0
Payable days = 90

Working Capital Cycle = 85 + 0 – 90 = –5

This means the company receives payment from customers 5 days before it has to pay its suppliers.

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 cents on the dollar, 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.

Working Capital Cycle in Financial Modeling

In financial modeling and valuation, one of the key sets of assumptions that are made about a company is in regard to its accounts receivable days, inventory days, and accounts payable days.

When building a financial model, it is important to clearly lay out these assumptions and understand their impact on the business.

To learn more, check out CFI’s online financial modeling courses.

Additional Resources

Thank you for reading this guide to understanding the importance of carefully managing a company’s working capital cycle. To advance your path towards this credential, these additional CFI resources will be helpful:

Proper management of working capital is essential to a company’s fundamental financial health and operational success as a business. A hallmark of good business management is the ability to utilize working capital management to maintain a solid balance between growth, profitability and liquidity.

A business uses working capital in its daily operations; working capital is the difference between a business's current assets and current liabilities or debts. Working capital serves as a metric for how efficiently a company is operating and how financially stable it is in the short-term. The working capital ratio, which divides current assets by current liabilities, indicates whether a company has adequate cash flow to cover short-term debts and expenses.

The goal of working capital management is to maximize operational efficiency.
Efficient working capital management helps maintain smooth operations and can also help to improve the company's earnings and profitability.
Management of working capital includes inventory management and management of accounts receivables and accounts payables.

Working capital is a daily necessity for businesses, as they require a regular amount of cash to make routine payments, cover unexpected costs, and purchase basic materials used in the production of goods.

Efficient working capital management helps maintain smooth operations and can also help to improve the company's earnings and profitability. Management of working capital includes inventory management and management of accounts receivables and accounts payables. The main objectives of working capital management include maintaining the working capital operating cycle and ensuring its ordered operation, minimizing the cost of capital spent on the working capital, and maximizing the return on current asset investments.

Working capital is an easily understandable concept, as it is linked to an individual’s cost of living and, therefore can be understood in a more personal way. Individuals need to collect the money that they are owed and maintain a certain amount on a daily basis to cover day-to-day expenses, bills, and other regular expenditures.

Working capital is a prevalent metric for the efficiency, liquidity and overall health of a company. It is a reflection of the results of various company activities, including revenue collection, debt management, inventory management and payments to suppliers. This is because it includes inventory, accounts payable and receivable, cash, portions of debt due within the period of a year and other short-term accounts.

The needs for working capital vary from industry to industry, and they can even vary among similar companies. This is due to several factors, including differences in collection and payment policies, the timing of asset purchases, the likelihood of a company writing off some of its past-due accounts receivable, and in some instances, capital-raising efforts a company is undertaking.

When a company does not have enough working capital to cover its obligations, financial insolvency can result and lead to legal troubles, liquidation of assets, and potential bankruptcy.

Working capital management is essentially an accounting strategy with a focus on the maintenance of a sufficient balance between a company’s current assets and liabilities. An effective working capital management system helps businesses not only cover their financial obligations but also boost their earnings.

Managing working capital means managing inventories, cash, accounts payable and accounts receivable. An efficient working capital management system often uses key performance ratios, such as the working capital ratio, the inventory turnover ratio and the collection ratio, to help identify areas that require focus in order to maintain liquidity and profitability.