Working Capital Cycle: Meaning and Measurements (With Formula) (2024)

Let us make an in-depth study of the meaning and measurements of operating cycle.

Meaning of Operating Cycle:

Every business organisation needs adequate working capital because the conversion of cash into finished goods to debtors and back to cash is not instantaneous.

It takes some time. For example, in a manufacturing firm, cash is used to purchase raw materials.

They are not consumed immediately. They remain some time in stores in order to ensure smooth production and to protect the firm against the risk of non-availability of raw materials in future.

Then they are issued from stores to production centre for conversion. This conversion also generally takes some time. When certain expenses such as wages and overheads are incurred on it, it gets itself converted into semi-finished goods or work-in-progress and, finally, into finished goods.

These finished goods will have to be stored for some time before sale. Next, finished goods are sold to customers which may take the form of cash or receivables/debtors. Receivable/ debtors, when realised, again take the form of cash and the cycle starts again.

This can be explained with the help of the following diagram:

The continuing flow from cash to suppliers, to inventory, to accounts receivable and back into cash is called the working capital cycle or operating cycle. In other words, the term operating cycle refers to the length of time which begins with the acquisition of raw materials of a firm and ends with the final realisation of cash from debtors.

The amount of working capital depends upon the length of working capital cycle. Longer the working cycle, higher is the need of working capital to be maintained. This is because the fund will then remain tied-up in various items of current assets for a longer period. The length of operating cycle varies from industry to industry and from business to business.

A merchandising concern will have a shorter operating cycle as it deals in finished products. On the other hand, in a service enterprise, operating cycle is shortest and involve conversion of cash into debtors and debtors into cash.

Thus, if raw materials remain in store for, say, 30 days, the conversion or processing period is 45 days, finished goods remain in store for 30 days and debts collection period is 40 days then the total of this period (i.e., 30 + 45 + 30 + 40 or 145 days) is referred to as Gross Operating Cycle. Business enterprises receive credit in the purchase of raw materials from suppliers. This payment deferral period reduces the length of working capital.

The net-working cycle period is ascertained by deducting from gross operation cycle the payment deferral period or period of credit granted by suppliers of raw materials. If period of credit given by supplier is 45 days, then Net Operating Cycle is 100 days (i.e., 145 days – 45 days).

Similar conclusions can also be drawn for other elements of cost i.e., for direct wages and overheads. In the case of direct wages and overheads, the operating cycle starts with the work- in-progress or processing time as there will be no raw materials storage period.

Measurement of Operating Cycle:

Strictly speaking, the volume of working capital depends upon the length of working capital cycle. So, it is important to measure working capital cycle for management of working capital. The financial statements i.e., Profit and Loss Account and Balance Sheet, can guide us to measure working capital cycle.

The procedure can be summarised:

1. Raw Material Storage Period:

It represents the average period during which raw materials are kept in stores.

It is calculated as:

If consumption of raw material is not available, average daily purchase can also be taken.

2. Processing Period:

Once materials are issued to production, it again involves time gap between issue of materials and production of finished product. This time gap is called processing period.

It is calculated as:

Factory cost of production during the year = Raw materials consumed + Direct wages + Other direct expenses + Manufacturing overhead + Opening WIP – Closing WIP.

3. Finished Goods Storage Period:

Manufacturing enterprises produce the output in the expectation of future demand. Till the demand for finished product materializes, the product would remain in the store. This period is termed as finished goods storage period.

This is calculated as:

Cost of goods sold = Opening stock of finished goods + Factory cost of production – Closing stock of finished goods.

4. Credit period Allowed to Debtors:

The business enterprises—due to competitive and other reasons—extend credit facilities to customers. The time gap between sale and realisation of cash is known as credit or collective period from debtors.

It is computed as:

5. Credit Period Received from Suppliers:

The business enterprises receive credit in the purchase of raw materials from suppliers. It refers to the average time taken for payment to suppliers from the date of purchase.

It is computed as:

Illustration 1:

The following information is available for Swagat Ltd.:

You are require to calculate:

(i) Duration of raw material stage

(ii) Duration of WIP stage

(iii) Duration of Finished goods stage

(iv) Duration of accounts receivable stage

(v) Duration of accounts payable stage, and

(vi) Duration of operating cycle.

Illustration 2:

Calculate the operating cycle from the following figures:

The company obtains a credit for 60 days from the suppliers. All goods are sold for credit. Assume 360 days in the year.