Working capital operating cycle

Investment in working capital is influenced by four key events in the production and sales cycle. These events are: purchase of raw materials, payment for their purchase, the sale of finished goods, and collection of cash for the sales made.

Definition of operating cycle

The time lag between the purchase of raw materials and the collection of cash for sales is referred to as the operating cycle for the company.
The time lag between the payment for raw materials purchases and the collection of cash from sales is referred to as the cash cycle.

Operating cycle of the company

The entire sequence of operations in a company can be summarised as follows:

• The operating cycle for a company primarily begins with the purchase of raw materials, which are paid for after a delay representing the creditor's payable period.
  
• These purchased raw materials are then converted by the production unit into finished goods and then sold. The time lag between the purchase of raw materials and the sale of finished goods is known as the inventory period.
• Upon sale of finished goods on credit terms, there exists a time lag between the sale of finished goods and the collection of cash on sale. This period is known as the accounts receivables period.

The following ratios will help in managing debtors, creditors and inventories

1. Stock Turnover ratio = Cost of goods sold / Average Stock

2. Debtors Turnover ratio = [(Debtors+ Bills receivable*365] / Net credit sales

3. Debtors Turnover rate = Credit sales / (Average Debtors + Bills receivable )

4. Creditors Turnover ratio = [(Creditors + Bills payable)*365] / Credit purchases

5. Creditors Turnover rate = Credit purchases / Average Creditors

The operating cycle can be depicted as:

• The stage between purchase of raw materials and their payment is known as the creditors payables period.
  
• The period between purchase of raw materials and production of finished goods is known as the inventory period.
  
• The period between sale of finished goods and the collection of receivables is known as the accounts receivable period.