The working capital cycle measures how quickly a business can turn its current assets into cash. Understanding how it works can help small business owners manage their company’s cash flow, improve efficiency, and make money faster.This blog post will 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 offer tips on managing the working capital cycle and making it work for your business.
What Is Working Capital?
There are a few key phrases that you should understand to calculate working capital for your business. In the section below, we’ll review some common terms needed to manage working capital properly.To start, you should understand net working capital, which means you’ll need to understand your current assets.
Current Assets
Current assets can be converted to cash in a short period; “current” or “short term” typically refers to one year in financial parlance. A business’s current assets might include the following:
Inventory
Accounts receivable
Prepaid expenses
Short-term investments
It’s important to note that your current assets don’t include long-term, fixed assets, such as real estate or equipment.Next, you should calculate your business’s current or short-term liabilities, detailed in the following section.
Current Liabilities
Your firm’s current liabilities are its debts and obligations within the same period. A business’s current liabilities include:
Vendor bills
Payroll expenses
Existing 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.The working capital cycle begins when you obtain assets to start the operating cycle and ends when the sale of a product or service converts to cash.Ultimately, the working capital ratio 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, a financial statement that details your business’s assets, capital, and liabilities.Referring to your balance sheet often will enable you to review how much positive working capital you have so that you can adjust cash conversion cycles or other factors. To learn about other factors that will affect your working capital cycle, keep reading!
What Affects the Working Capital 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, you can measure the working capital cycle by how long inventory takes to move and the number of days it takes to receive a 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.
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 bills are due. A negative working capital cycle is achievable by revising various stages, 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 accrued 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.Ultimately, it would help if you tried to shorten the working capital cycle. The faster your business converts assets to cash, the sooner that funds are available for use to run and grow your operations.Small business owners who fall short might turn to business financing options, such as a revolving credit line, cash advance, or business loan, to bridge these gaps in cash flow. It can be beneficial to receive additional funds to grow your business further.Editor’s Note: This post was updated for accuracy and comprehensiveness in April 2022.
