Question

What is the working capital cycle and why is it important? How does working capital relate to the cash flow statement?

Answer 1

What is working capital cycle?

Working Capital cycle (WCC) refers to the time taken by an organization to convert its net current assets and current liabilities into cash. It reflects the ability and efficiency of the organization to manage its short-term liquidity position. In other words, the working capital cycle (calculated in days) is the time duration between buying goods to manufacture products and generation of cash revenue on selling the products. The shorter the working capital cycle, the faster the company is able to free up its cash stuck in working capital. If the working capital cycle is too long, then the capital gets locked in the operational cycle without earning any returns. Therefore, a business tries to shorten the working capital cycles to improve the short-term liquidity condition and increase their business efficiency.

The working capital cycle focuses on management of 4 key elements viz. cash, receivables (debtors), payables (creditors) and inventory (stock). A business needs to have complete control over these four items in order to have a fairly controlled and efficient working capital cycle.

Why is it important?

A positive working capital cycle balances incoming and outgoing payments to minimize net working capital and maximize free cash flow. For example, a company that pays its suppliers in 30 days but takes 60 days to collect its receivables has a working capital cycle of 30 days. This 30-day cycle usually needs to be funded through a bank operating line, and the interest on this financing is a carrying cost that reduces the company's profitability. Growing businesses require cash, and being able to free up cash by shortening the working capital cycle is the most inexpensive way to grow. Sophisticated buyers closely review a target's working capital cycle because it provides them with an idea of the management's effectiveness at managing their balance sheet and generating free cash flow.

How does working capital relate to the cashflow statement?

Changes in working capital are reflected in a firm’s cash flow statement. Here are some examples of how cash and working capital can be impacted.

If a transaction increases current assets and current liabilities by the same amount, there would be no change in working capital. For example, if a company received cash from short-term debt to be paid in 60 days, there would be an increase in the cash flow statement. However, there would be no increase in working capital, because the proceeds from the loan would be a current asset or cash, and the note payable would be a current liability since it's a short-term loan.

If a company purchased a fixed asset such as a building, the company's cash flow would decrease. The company's working capital would also decrease since the cash portion of current assets would be reduced, but current liabilities would remain unchanged because it would be long-term debt.

Conversely, selling a fixed asset would boost cash flow and working capital.

If a company purchased inventory with cash, there would be no change in working capital because inventory and cash are both current assets. However, cash flow would be reduced by inventory purchases