What is working capital (WC) and what is the working capital cycle?
WC refers to the investment a firm has made in AR, INV. minus the AP. The WC cycle refers to the continuous changes in these items (which occur in a cycle) – for example, AP is incurred because of Inventory (raw material and/or finished goods) purchases which becomes AR through Sales and this is converted to Cash which is used to pay AP and then new raw material and/or finished goods are purchased for Inventory which is then sold and so on, making this a continuous cycle. For a business to be (and remain) healthy this cycle has to be managed actively. Also it needs to know the appropriate level of investment it needs in each component.
How do you do this? First, you must understand what level of money and time is appropriate as working capital… When sales are made your credit terms are 30 days, 45 days or 60 days usually. This means AR collections will come after this time has elapsed. What amount of Inventory should you carry – 30 days of sales or 45 days? These times will determine the amount of money needed. How long will you take to pay AP – 30, 45 or 60 days? This is the loan you are getting from your suppliers and then you deduct this from the former two, to arrive at the WC investment you need. This is the start, then how do you manage this? You do this by constructing ratios – Days sales outstanding (DSO) Days Inventory outstanding (DIO) and days payable outstanding (DPO) that will tell you whether, in relation to sales each of these components are increasing or decreasing. These ratios are commonly constructed by your accounting people and when tracked over a period of time indicates the health of your WC. Also, these ratios can tell you the relationship amongst each of these components – are your AR too high when your Inv is too low?