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Working capital cycle in a manufacturing business
Average time raw materials are in stock
+
Time taken to produce goods
Time taken by customers to pay for goods
Period of credit taken from suppliers
=
Working capital cycle (in days)
(Raw materials / purchases)x 365 days
(WIP & finished goods / cost of sales)x 365 days
(Trade receivables / credit sales)x 365 days
-(Trade payables / purchases)x 365 days
Please note that for "trade payable days" calculation, if information about credit purchases isn't known then cost of sales is used instead.
The shorter the cycle, thebetter it is for the company as it means:
Inventories are moving though the organisation rapidly.
Trade receivables are being collected quickly.
The organisation is taking the maximum credit possible from suppliers.
The shorter the cycle, the lower the company's reliance on external supplies of finance such as bank overdrafts which is costly.
Excessive working capital means too much money is invested in inventories and trade receivables. This signifies lost interest or excessive interest paid and lost opportunities (funds could be invested elsewhere and earn a higher return).
The longer the working capital cycle, the more capital is required to finance it.
Exam questions generally ask how working capital can be managed effectively. To answer the question you need to discuss overall working capital levels, and then individual components such as stock, debtors and creditors.
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