The working capital cycle As an introduction to the working capital cycle, here is a quick reminder of the main types

of cash inflow and outflow in a typical business: Inflows Cash sales to customers Receipts from customers who were allowed to buy on credit (trade debtors !nterest on bank and other balances Proceeds from sale of fi"ed assets !n#estment by shareholders Outflows Purchasing finished goods for re-sale Purchasing raw materials and other components needed for the manufacturing of the final product Paying salaries and wages and other operating e"penses Purchasing fi"ed assets Paying the interest on, or repayment of loans Paying ta"es Cash flow can be described as a cycle:

$he business uses cash to acquire resources (assets such as stocks $he resources are put to work and goods and ser#ices produced% $hese are then sold to customers &ome customers pay in cash (great , but others ask for time to pay% '#entually they pay and these funds are used to settle any liabilities of the business (e%g% pay suppliers And so the cycle repeats

(opefully, each time through the cash flow cycle, a little more money is put back into the business than flows out% )ut not necessarily, and if management don*t carefully monitor cash flow and take correcti#e action when necessary, a business may find itself sinking into trouble% $he cash needed to make the cycle abo#e work effecti#ely is known as working capital. Working capital is the cash needed to pay for the day to day operations of the business. !n other words, working capital is needed by the business to:

Pay suppliers and other creditors Pay employees Pay for stocks

Allow for customers who are allowed to buy now, but pay later (so-called +trade debtors,

-hat is crucially important, therefore, is that a business actively manages working capital% !t is the timing of cash flows which can be #ital to the success, or otherwise, of the business% .ust because a business is making a profit does not necessarily mean that there is cash coming into and out of the business% $here are many ad#antages to a business that acti#ely manages its cash flow:

!t knows where its cash is tied up, spotting potential bottlenecks and acting to reduce their impact !t can plan ahead with more confidence% /anagement are in better control of the business and can make informed decisions for future de#elopment and e"pansion !t can reduce its dependence on the bank and sa#e interest charges !t can identify surpluses which can be in#ested to earn interest

What It Measures
$he working capital cycle measures the amount of time that elapses between the moment when your business begins in#esting money in a product or ser#ice, and the moment the business recei#es payment for that product or ser#ice% $his doesn*t necessarily begin when you manufacture a product0businesses often in#est money in products when they hire people to produce goods, or when they buy raw materials%

Why It Is Important
A good working capital cycle balances incoming and outgoing payments to ma"imi1e working capital% &imply put, you need to know you can afford to research, produce, and sell your product% A short working capital cycle suggests a business has good cash flow% 2or e"ample, a company that pays contractors in 3 days but takes 45 days to collect payments has 64 days of working capital to fund0also known as ha#ing a working capital cycle of 64 days% Ama1on%com, in contrast, collects money before it pays for goods% $his means the company has a negati#e working capital cycle and has more capital a#ailable to fund growth% 2or a business to grow, it needs access to cash0and being able to free up cash from the working capital cycle is cheaper than other sources of finance, such as loans%

How It Works in Practice

$he key to understanding a company*s working capital cycle is to know where payments are collected and made, and to identify areas where the cycle is stretched0and can potentially be reduced%

$he working capital cycle is a diagram rather than a mathematical calculation% $he cycle shows all the cash coming in to the business, what it is used for, and how it lea#es the business (i%e%, what it is spent on % A simple working capital cycle diagram is shown in 2igure 7% $he arrows in the diagram show the mo#ement of assets through the business0including cash, but also other assets such as raw materials and finished goods% 'ach item represents a reser#oir of assets0for e"ample, cash into the business is con#erted into labor% $he working capital cycle will break down if there is not a supply of assets mo#ing continually through the cycle (known as a liquidity crisis %

2igure 7% A simple working capital cycle diagram

$he working capital diagram should be customi1ed to show the way capital mo#es around your business% /ore comple" diagrams might include incoming assets such as cash payments, interest payments, loans, and equity% !tems that commonly absorb cash would be labor, in#entory, and suppliers% $he key thing to model is the time lag between each item on the diagram% 2or some businesses, there may be a #ery long delay between making the product and recei#ing cash from sales% 8thers may need to purchase raw materials a long time before the product can be manufactured% 8nce you ha#e this information, it is possible to calculate your total working capital cycle, and potentially identify where time lags within the cycle can be reduced or eliminated%

Tricks of the Trade

2or in#estors, the working capital cycle is most rele#ant when analy1ing capitalintensi#e businesses where cash flow is used to buy in#entory% $ypically, the working capital cycle of retailers, consumer goods, and consumer goods manufacturers is critical to their success% $he working capital cycle should be considered alongside the cash con#ersion cycle 0a measure of working capital efficiency that gi#es clues about the a#erage number of days that working capital is in#ested in the operating cycle