Mastering Working Capital and Cash Conversion Cycles

Understanding Working Capital

Working capital is a business investment in short-term assets, such as cash, marketable securities, accounts receivable, and inventories.

• Working capital represents the ability of a company to develop its activities normally in the short term. It can be calculated as the excess of assets over current liabilities.
• Working capital measures the company's equity balance. This is a very important tool for internal analysis, reflecting a close relationship with daily business operations.
• When current assets are greater than current liabilities, we speak of positive working capital. This means the company has more cash than debt maturing in the short term.
• Conversely, negative working capital reflects an imbalance, which does not necessarily mean the company is in bankruptcy or has suspended payments.
• Negative working capital implies a need to increase current assets. This can be done through the sale of fixed or current assets to obtain available cash. Other possibilities include a capital injection or obtaining long-term debt.

The Cash Conversion Cycle

The cash conversion cycle is the time lag from the payment for raw materials needed to manufacture a product to the collection of the sale of that product. This ratio measurement is also known as the cash cycle and is calculated using the following formula:

CCE = PCI + PCC - PCP

Where:

• PCI: Inventory conversion period.
• PCC: Collection period of accounts receivable.
• PCP: Period in which accounts payable are deferred.

• The cash conversion cycle is used to gain a better perspective on decisions regarding working capital.
• The maturation cycle is the time it takes to recover money.

Optimizing the Maturation Cycle

• All companies seek to exploit the best of their own operations; when making decisions about working capital, there must be a focus on creating value for the company.
• The average period of maturation, or ripening, can also be represented by a Gantt chart. This cycle represents the days elapsed from the purchase of raw materials until the customer is charged.
• The goal of any business is for the cycle to be as short as possible. Knowledge of this cycle is useful for calculating the necessary financial cushion and adequate funding to manage it.