The volume of working capital depends on the amount blocked in current assets. These amounts are released over a time period and gradually changes shape from one item to another. This changing process rotates in a cyclical order.
The length of the cycle or the time taken to rotate the cycle once is known as the working capital cycle or the operating cycle.
The operating cycle of a company can be said to cover distinct stages, each stage requiring a level of supporting investment. The time gap between the firm’s paying cash for materials, entering into work in process, making finished goods, selling finished goods to the debtors and the inflow of cash from debtors is known as working capital or operating cycle. According to the nature of business the duration of working capital cycle varies. It is the responsibility of the finance manager to shorten the length of working capital cycle.
For a manufacturing firm, the cycle starts with the investment made in raw materials and other components. The inventories can be bought on trade credit as a result creditors will increase. Further goods are manufactured that are sold on credit as a result debtors will increase. Finally debtors pay in the form of cash or cheque and consequently creditors are paid out. How cash makes its journey through different stages has been depicted in Figure 7.3.
Reasons for a Longer Operating Cycle:
Working capital requirements depend on the operating cycle. It starts with payment for acquisition of raw materials and ends with the collection of receivables from debtors. The duration of the working capital cycle varies according to the nature of business.
The reasons for longer operating cycle are given below:
- Firstly the working capital cycle may be longer if the availability of raw materials is not easy. As a result the organization will have to hold large amount of raw materials in stores.
- Secondly the processing period may be longer. The nature of the product is such that the product passes through various departments to get finished.
- Thirdly the product may be slow moving. In that case the time taken to deplete the finished goods stock will be longer.
- Finally the credit policy and the inefficiency of the organization in debt collection also increase the length of operating cycle.