Estimating working capital needs is critical when starting up a new business, and when going through a period of growth and expansion.  By understanding the cycles a business goes through, and assigning some numbers to them, it is possible to come up with a realistic estimate of how much working capital you should have on hand.  And, when a business is experiencing financial difficulties, an analysis of these cycles and the impact they have on cash flow and resources enables taking the necessary steps to turn the situation around.

Working Capital Cycle and Cash Conversion Cycle

A production environment, whether large or small, may serve as a good example for defining the different stages a business operation goes through, from the time commitments are made for raw materials, supplies, and services, until payment is received from the customer for the final product sold. 

Working capital includes inventory, payables, and receivables, so the working capital cycle covers the period from when commitments are first made until payment is received from the customer.  The working capital cycle may differ from the cash conversion cycle, since goods and services may be purchased on credit; certain expenses such as salaries, wages, and utilities accrue during the period; and sales to the customer may be on credit terms.  So, the cash conversion cycle is the time from payment of accruals to collection of receivables.  It is the amount of time cash is tied up in the cycle, and not available for other purposes.

Throughout the process, incremental costs will continue to be added and will need to be financed with working capital until payment is received and the cycle is complete. For example, at the start of the production period the costs are in raw materials.  As production begins, costs for labor, supplies, and overhead are added.  When finished goods are placed in inventory, storage costs may be incurred.  And the sale of the products to customers may involve shipping costs, commissions, or other selling expenses.  Working capital requirements increase as the business cycle progresses.

Ongoing Cycles

Another point to take into consideration is that cycles are ongoing.  Purchases and collections may be made every day during the period, so the cycle for one particular product overlaps with the cycle for another product.  The cycle is constantly repeating itself, and at any given point in time, each individual cycle will be at a different stage of completion.  The idea is to come up with a way to determine average balances for inventory, payables and receivables in order to determine an overall estimate of working capital needs.