9.6 Working capital operating cycle; the importance and computation of the working capital operating cycle

The working capital operating cycle, also known as the cash conversion cycle, is a measure of the time it takes for a company to convert its investments in inventory and accounts receivable back into cash. It represents the period from the initial outlay of cash for inventory purchases to the collection of cash from the sale of finished goods.

The working capital operating cycle is important for businesses as it provides insights into the efficiency of their working capital management and cash flow generation. A shorter operating cycle indicates faster cash conversion, which implies better liquidity and operational efficiency. Conversely, a longer operating cycle suggests that a company takes more time to convert its investments into cash, leading to potential liquidity constraints.

The working capital operating cycle can be computed using the following components:

1. Inventory Conversion Period: This represents the average time it takes for a company to convert its raw materials and components into finished goods ready for sale. It is calculated as:Inventory Conversion Period = (Average Inventory / Cost of Goods Sold) * 365

   The average inventory is the average of opening and closing inventory balances.

2. Receivables Collection Period: This represents the average time it takes for a company to collect payment from its customers for credit sales. It is calculated as:Receivables Collection Period = (Average Accounts Receivable / Net Credit Sales) * 365

   The average accounts receivable is the average of opening and closing accounts receivable balances, and net credit sales exclude cash sales.

3. Payables Deferral Period: This represents the average time a company takes to pay its suppliers for credit purchases. It is calculated as:Payables Deferral Period = (Average Accounts Payable / Cost of Goods Sold) * 365

   The average accounts payable is the average of opening and closing accounts payable balances.

The working capital operating cycle is computed by adding the inventory conversion period and the receivables collection period and subtracting the payables deferral period:

Working Capital Operating Cycle = Inventory Conversion Period + Receivables Collection Period – Payables Deferral Period

A shorter working capital operating cycle indicates efficient working capital management, as the company is able to convert its investments into cash quickly. This helps improve liquidity, reduces the need for external financing, and allows the business to fund its operations more effectively. It also reduces the risk of inventory obsolescence and credit default.

Monitoring and managing the working capital operating cycle is important for businesses to identify areas of improvement, streamline processes, and optimize cash flow management. By reducing the operating cycle, a company can enhance its financial performance, improve profitability, and strengthen its competitive position.