What is a Working Capital Cycle?
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.
In this post, we’ll provide a breakdown of what a working capital cycle is, what affects it, and how it can affect your small business’s finances. We’ll also provide tips on how you can manage the working capital cycle and make it work for your business.
What Is Working Capital?
To understand net working capital, you should know what your current assets 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. To learn about other factors that will affect your working capital cycle, keep reading!
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 60 days to turn inventory into cash, and the bill for inventory is due in 30 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.
Conclusion: Make Sure Your Team Understands the Working Capital Cycle
A crucial aspect of running a business is managing when and how money comes and goes from your company’s bank account. It isn’t enough to know that you’re making a profit. Your revenues may exceed expenses, but it doesn’t account for how long customers take to pay. In the meantime, you still need cash to pay your suppliers and employees, service debt, and keep the lights on.
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.
Editor’s Note: This post was updated for accuracy and comprehensiveness in January 2019.
Editorial Note: Any opinions, analyses, reviews or recommendations expressed in this article are those of the author's alone, and have not been reviewed, approved, or otherwise endorsed by any of these entities.