Working Capital Cycle
The college textbook definition of working capital is current assets minus payables and accrued expenses. The term explains the dollar value of flexibility a business operation has to take advantage of immediate opportunities or endure sudden or long-term setbacks. Since it is a balance sheet based formula, the value is a function of a moment in time. However, working capital changes over time depending on the nature of the business and the time period scrutinized. Let’s look at an easy to understand example:
A small chocolate candy manufacturing operation makes a tasty peanut butter chocolate covered Easter egg as a product sold to churches for Easter time fundraising. It weighs about one pound and is as large as good size jar. The churches pay for their orders 10 days after Easter. In anticipation of demand, orders are taken up to 90 days before Easter to determine quantity of supplies needed. Supplies are ordered and delivered with 60 days left until Easter. Payment for supplies is paid with 30 days to go to till Easter. Labor and other costs to manufacture are paid prior to delivery. Yet not one sale to a church has occurred. All of these costs are accrued into inventory. Ultimately the eggs are sold. Inventory value along with profit is transferred via sales to accounts receivable and then finally into cash as the various churches pay their invoices.
In this example working capital in the form of cash is used to purchase raw resources needed to make the product. It takes about 90 days before the cash account is completely reimbursed via collections of receivables. This start to finish period of time is called ” the ‘Working Capital Cycle’.
In the article Working Capital, it states the best form of working capital is cash net of payables and accrued expenses. This is the amount that is truly flexible and usable to take advantage of an opportunity. The working capital cycle refers to the flow of cash and how it changes into other current assets then back into cash. As it cycles through these stages the business should make it more valuable because of profitability on the sale of products or services.
The following are the various stages that occur in a typical working capital cycle. In the sections that follow I illustrate with various business operations these respective steps. Finally I provide examples of business operations and their working capital durations (cycles).
Step I – Planning provided by management
Step II – Purchase of materials and supplies
Step III – Conversion including labor costs
Step IV – Delivery
Step VI – Sales and conversion of inventory into receivables
Step VII – Payment of bills
Step VIII – Receivables back into cash
Step I – Planning
This is the most important step in this cycle. Management needs to understand how much cash or current asset resources are needed to complete the cycle without impeding other needs for cash such as overhead expenses, tax obligations and routine maintenance requirements. Planning is covered in more detail in the next article in this series -Working Capital Management.
Step II – Purchases of Materials and Supplies
Just about every business in operation has to buy the necessary materials and supplies to get the job done. Many service based operations take this step with finding the right talent and conducting training. For product manufacturers it may involve only one or two raw resources. But the key here is that both current assets and current liabilities receive an equal debit and credit to their accounts.
Current Assets – Raw Materials increase (Inventory goes up)
Current Liabilities – Accounts Payable increase
A perfect example is glass manufacturing (bottle making). Their current assets section for inventory is divided into three major accounts 1) raw materials, 2) supplies and 3) finished products. The raw materials are transformed into finished products using a heating and molding process. Once the the bottles are cooled, they are labeled, packaged, boxed and palletized. The inventory section reflects this process:
– Silica Sand $ZZ,ZZZ
– Limestone Z,ZZZ
– Soda Ash Z,ZZZ
– Crushed Recycled Glass ZZ,ZZZ
Sub-Total Raw Materials $ZZ,ZZZ
– Corrugated Spacers $Z,ZZZ
– Labels Z,ZZZ
– Packages ZZ,ZZZ
– Boxes Z,ZZZ
– Clear Bottles ZZZ,ZZZ
Sub-Total Supplies ZZZ,ZZZ
– Brown Bottles $ZZZ,ZZZ
– Green Bottles ZZ,ZZZ
Sub-Total Finished Products ZZZ,ZZZ
Total Inventory $ZZZ,ZZZ
Basically a glass manufacturer buys raw materials and supplies then adds heat and labor to create a finished product. During the process the debit balances in the raw materials and supplies move down into finished products by simply crediting raw materials along with supplies reducing their balances and debiting finished products. This transition occurs everyday. As materials are purchased either raw materials or supplies increase and so do the corresponding payables.
Step III – Conversion: Adding Labor and Other Costs
Conversion is the process of adding labor to the materials and bringing a product to the final stage of readiness for the customer. In manufacturing it is the actual production line labor and management costs to turn raw materials into finished goods. In other industries there may be more labor involved to bring the raw resources to the level of compliance. For example:
Zach’s plumbing does plumbing work for new home construction. In a typical arrangement with a contractor the project has three phases. The first phase involves site work whereby the main water line is tapped and the sewer line is drawn down from the home’s foundation to the main drop at the curb. To complete this step Zach runs a 1/2″ copper tube insulated and inserted into a PVC tube in an underground path to the house. A meter is installed and the system is wrapped with electrical heating tape for wintertime compliance. The sewer line is a 4″ PVC line with two clean-outs. Zach invests the following into this phase of the project:
Equipment Rental 142
Zach waits until all three phases are completed to invoice the contractor. Usual time frame for one project is about nine months and Zach does about 35 projects per year.
On Zach’s balance sheet the phase value is accrued to work in process and assigned a control ID for the particular house. Since Zach pays cash for materials and labor it is merely a simple transfer of cash to the inventory account (work in process). More importantly, note the duration of this cycle. Over the remaining eight months Zach will invest several thousand dollars for materials, labor, transportation, insurance and permits to complete the job. All of it is paid with cash. Zach’s work in process builds up over time for this project.
Other industries are extremely labor intensive like movie production or even putting together a musical concert. Sometimes labor is intensive at the moment of the sale, think of sales commissions for dealerships or the work to provide fine dining.
In other situations conversion may include costs such as transportation or adding energy (think ore smelting to produce metal) to create the final product. For the reader the most common conversion cost is labor, in most cases conversion costs dictate payment to the suppliers including employees prior to delivering or selling the product.
Step IV – Delivery
The last step in the product to market aspect of the working capital cycle is delivery to the customer. Once delivered there is performance under contract law and then the business can record a sale.
Delivery is different in every industry. Sometimes it is as simple as handing the item to the customer like in retail or using elaborate systems such as electrical energy to a household consumer. For most businesses delivery is another working capital cost.
Step V – Sales and Accounts Receivable
Now for one of the more fun parts of the working capital cycle – the final sale. For many small businesses the cycle is completed here because it is a cash based sale. Food service, retail, automotive repair and more do not extend credit to their customers. For those that do extend credit, both the cost of the product or service and the profit earned are posted as an account receivable. At the same moment inventory for the item is credited and the cost of the item including conversion costs is transferred to cost of sales. This economic transaction transfers the inventory value to accounts receivable plus the profit earned. Current assets increases by the gross profit earned and accounts payable stay the same. Notice several key changes of business after completing this sale:
- Gross working capital (total current assets) increases by the amount of the profit. The inventory value is merely a component of the invoice value now in receivables.
- The current ratio increases (current assets/current liabilities); since accounts payable do not change the ratio improves.
- The quick ratio improves dramatically.
- Working capital as technically defined (current assets less accounts payable and accrued expenses) increases by the profit earned on the sale.
All of the above are balance sheet related, think about the income statement improvement too. To illustrate, review this example.
Bob owns a metal fabrication shop (machine shop) and one of his better customers is a railroad car repair company. Bob makes brake pad spacers for the brake system on each wheel. Each wheel uses four spacers. A typical rail car has eight wheels, so each car needs 32 spacers. It costs Bob around $3.50 to make a spacer including cost of materials, labor, tooling, packaging and palletizing. This customer orders spacers by sets of 2,000. A usual order is two sets (4,000 spacers) which Bob keeps in inventory. Bob’s cost per set is $7,000. He sells one set for $29,200. This is Bob’s balance sheet (current assets) before the sale:
Inventory (3 Sets of Spacers) 21,000
Total Current Assets $64,000
This is the balance sheet after an order and delivery of two sets of brake spacers:
Accounts Receivable 58,400
Total Current Assets $108,400
Notice the current assets increased by $44,400 which is the profit earned on the sale of the two sets of spacers (profit is $22,200 per set). Inventory decreased $14,000 which is the cost of goods sold as illustrated here:
Limited Income Statement
Cost of Sales:
Sub-Total Cost of Sales 14,000
Gross Profit $44,400
Step VI – Payment of Bills
This part of the cycle creates heartache for many an owner. Using cash to pay the liabilities depletes cash and for many small businesses it will drain the cash account to nearly zero. The net effect is gross working capital (current assets) decreases. Interestingly enough current and quick ratio increase because it is a one for one exchange. As an example if current assets are $18,000 and current liabilities are $14,000 and the company pays $10,000 of the accounts payable, what happens to these ratios? Before, the current ratio was 1.28 to 1 ($18,000/$14,000); now it is 2 to 1 ($8,000/$4,000).
Even though gross working capital decreases; working capital as a whole did not change! How so?
The formula is an equation with equal impact to both sides. As in the example used, both sides decreased $10,000. The before and after working capital balance is $4,000. For an owner of a small business the outlay of cash reduces his ability to absorb any emergency need for cash. The solution, collect on the accounts receivable.
Step VII – Cash
If all the receivables were paid at one time the cash account will have gone a complete 360 degree change. Notice in the working capital cycle that in the early steps the working capital merely changes classification via physical form. Raw materials are purchased on account, converted using labor and other costs (consuming cash) but working capital as a whole has not really changed. The current assets section has changed values in the respective accounts, e.g. cash decreases but finished goods increases by the same amount.
Only in Step V (Sale of Products/Services) does working capital actually increase in value. Working capital increases by the gross profit amount. But at the end of the day, management would prefer working capital in the form of cash. When the receivable is paid, the cash balance increases. Working capital stays the same though, its underlying form has changed from receivables to cash.
As an owner of small business the ideal operation allows you to receive the cash from the customer first then pay out for the supplies and labor. Good examples of these kinds of businesses include:
* Hair Salons
* Auto Repair
* Consignment Shops
* Dental Practices
But many small businesses don’t have this advantage and must collect the cash after paying for their supplies and labor. Examples include:
* Medical Practices
* Professional Firms
* Gasoline Stations
* Liquor Stores
For many small businesses managing the cycle becomes a priority. This is explained in more detail in the next article in this series.
The final aspect of the working capital cycle is understanding the cycle duration for different industries.
Working Capital Cycle
There is no one single working capital cycle period that fits all industries. Some are extremely short, like 8 hours.
- The corner food cart serving the lunch crowd in the city has a really short working capital cycle. In the morning the vendor stops at his local COSTCO or SAM’S Club and buys his supplies for the day with his working capital, sells to the lunch crowd and in the afternoon deposits the money right back into his account including the profit earned – eight hour cycle.
Some are several years long.
- The Tabasco Sauce Company grows and harvests the peppers costing money, dry the peppers and barrels the ground up peppers for aging. The barrels are stored in a warehouse and rotated frequently. Finally the raw resource is mixed with vinegar and other spices and now there is Tabasco Sauce. The working capital cycle varies from batch to batch but it is anywhere from a couple of years or longer depending on the quality of the peppers.
Most small businesses are from a few days to several months. Here are typical examples:
- Service based industries such as professional firms are typically 60 days in their cycles. Work is performed and accrued over 30 days. The invoice is then sent to the client and the client pays within 30 days.
- Retail is generally shorter than 30 days except for seasonal items that must be paid for well in advance of the actual shopping period.
- Construction is often nine months to upwards of a year. To alleviate the burden of having working capital invested this long, construction loans are issued shortening the cycles to about 45 days. The loans utilize draws (percentage of completion payments) to provide the necessary working capital.
- Medical practices typically cycle every 40 days depending on the insurance providers used by their patients.
- Government contractors can expect longer cycles often over 60 days due to the bureaucracy of the government’s processing and approval system for invoices.
The above illustrates that there is no one single duration of time that is universal for the working capital cycle. The key is that the cycle encompasses seven steps:
3) Conversion (cash out for labor)
6) Payment to suppliers (cash out)
7) Receivable payments (cash in)
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