working capital cycle
Introduction
The working capital cycle can be defined as:
The period of time which elapses between the point at which cash begins to be expended on the production of a product and the collection of cash from a customer
The diagram below illustrates the working capital cycle for a manufacturing firm
The upper portion of the diagram above shows in a simplified form the chain of events in a manufacturing firm. Each of the boxes in the upper part of the diagram can be seen as a tank through which funds flow. These tanks, which are concerned with day-to-day activities, have funds constantly flowing into and out of them.
• The chain starts with the firm buying raw materials on credit.
• In due course this stock will be used in production, work will be carried out on the stock, and it will become part of the firm’s work in progress (WIP)
• Work will continue on the WIP until it eventually emerges as the finished product
• As production progresses, labour costs and overheads will need to be met
• Of course at some stage trade creditors will need to be paid
• When the finished goods are sold on credit, debtors are increased
• They will eventually pay, so that cash will be injected into the firm
Each of the areas – stocks (raw materials, work in progress and finished goods), trade debtors, cash (positive or negative) and trade creditors – can be viewed as tanks into and from which funds flow.
Working capital is clearly not the only aspect of a business that affects the amount of cash:
• The business will have to make payments to government for taxation
• Fixed assets will be purchased and sold
• Lessors of fixed assets will be paid their rent
• Shareholders (existing or new) may provide new funds in the form of cash
• Some shares may be redeemed for cash
• Dividends may be paid
• Long-term loan creditors (existing or new) may provide loan finance, loans will need to be repaid from time to time, and
• Interest obligations will have to be met by the business.
Unlike movements in the working capital items, most of these ‘non-working capital’ cash transactions are not everyday events. Some of them are annual events (e.g. tax payments, lease payments, dividends, interest and, possibly, fixed asset purchases and sales). Others (e.g. new equity and loan finance and redemption of old equity and loan finance) would typically be rarer events.
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