How to control Working Capital for the business?

The control of Working Capital depends on the nature of the business. If someone asks how much time a city Bus will take to reach from place ‘X’ to place ‘Y’ (say distance between two places is 100 Kilometre(Km) and the average speed of the Bus is 50 Km per Hour, there are five Stops and at each Stop Bus stops for 10 minutes), you will simply calculate the total time required for covering the distance which is 2 Hours (Distance divide by Speed) and add 50 minutes of stoppage time, working out to total time of 2 Hours and 50 Minutes.

Similarly, in business also, the total amount of Working Capital money requires to calculate the total no. of days (remember the ‘distance’ for the Bus) money has to stay trapped in various forms (relax I will explain).

In a simple Grocery Shop business:

 -> You buy Stocks (i.e convert the Cash form into Stocks form; if you buy some Stocks from Vendor on credit basis then you also create Credit form which is required to be converted into Cash form later at the time of payment to Vendor),

-> Sale grocery items on credit to your customers (convert Stocks form into Debtors form),

-> Collect money from your Debtors (convert Debtors form into Cash form),

-> Pay to your Vendors for the credit availed (convert Credit form into Cash form)

What do you observe from the above? It is simply a cycle into which money gets converted in to various forms during the business process and at the last converts back into the form of Cash. This cycle is called the Operating Cycle.

In a manufacturing firm, Cash is used to purchase Raw Materials (RM) (purchased by paying in Cash which is rare or on credit terms thereby creating Creditors), RM is then processed and converted from one intermediate product form to another intermediate product form (called as Work in Progress) before taking the final shape of Finished product, Products are sold on credit (creating Debtors), payments are collected from Debtors and payments are also made to Creditors. The chain can be reflected as following:

Cash and Creditors (credit period says 5 days) - > RM (say 10 days) - > Work in Progress (say 6 days) - > Finished Products (say 4 days) - > Debtors (say 3 days) - > Cash net of payment to Creditors

=10 + 6 + 4 + 3 = 23 days (This is Called Gross Operating Cycle)

From the above, you need to deduct the 5 days credit period provided by the Supplier or Vendor because this is period for which there was no actual cash of manufacturing firm got trapped in the cycle, so:

 = 23 – 5 = 18 days (This is called Net Operating Cycle)

The control of Working Capital depends on the net no. of days money gets trapped into each of the above stages.

So, in order to control the Working Capital of the business, you first need to calculate the Operating Cycle.