A Business will typically need working capital when its operating cycle is too long. First, let’s define what an operating cycle is in a business.
The operating cycle is the average period of time required for a business to make an initial outlay of cash to produce goods, sell the goods, and receive cash from customers in exchange for the goods. If a company is a retailer, then the operating cycle does not include any time for production: it is simply the date from the initial cash outlay to the date of cash receipt from the customer.
Working Capital. Current Assets – Current Liabilities = Working Capital.
In this particular example if it takes a business let’s say 90 days to convert its initial outlay of cash for the purchase of goods for resell back into cash in the register, then this 90-day process exceeds the 30 days required for the typical operating expense cycle.
If this is the case, then the business will need approximately 60 days of working capital to pay its creditors.
The operating cycle is useful for estimating the amount of working capital that a company will need in order to maintain or grow its business. A company with an extremely short operating cycle requires less cash to maintain its operations, and so can still grow while selling at relatively small profit margins.
Conversely, a business may have high margins and yet still require additional financing to grow even if its operating cycle is somewhat long.
The following are all factors that influence the duration of the operating cycle and cash cycle:
- The payment terms extended to the company by its suppliers. Longer payment terms shorten the operating cycle since the company can delay paying out cash.
- The order fulfillment policy. Since a higher assumed initial fulfillment rate increases the amount of inventory on hand, which increases the operating cycle.
- The credit policy and related payment terms. Since looser credit equates to a longer interval before customers pay, which extends the operating cycle.
Typically, management decisions can impact the operating cycle of a business. Therefore it is extremely important for every business to have a handle on its operating cycle so it can predict how much working capital is either needed or on hand at a particular point.
If your operating cycle is too long you may benefit from additional working capital to meet your current obligations.
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