This lesson explains the concept of the working capital cycle and analyses how changes in its components affect the liquidity position of an organisation.
3.1 The Working Capital Cycle
Working capital is the capital required to fund the day-to-day operations of a business, calculated as current assets minus current liabilities. The working capital cycle measures the time it takes for a company to convert its investments in inventory and other resources into cash flows from sales. It is a key concept in the ACT syllabus, which requires the learner to “Analyse the liquidity needs of the organisation by using the key stages of the working capital cycle” .
The working capital cycle consists of three key components:
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Days Payable Outstanding (DPO):Â The average number of days the company takes to pay its suppliers.
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Days Sales Outstanding (DSO):Â The average number of days it takes to collect cash from customers after a sale.
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Days Inventory Outstanding (DIO):Â The average number of days the company holds inventory before selling it.
The cash conversion cycle is calculated as DSO + DIO – DPO. A shorter cash conversion cycle indicates that a company can convert its investments into cash more quickly, reducing the need for external financing.
3.2 The Relationship Between Working Capital and Liquidity
Changes in any component of the working capital cycle directly impact liquidity. The ACT syllabus requires learners to analyse “the impact of working capital changes on the cash and liquidity position of the organisation” through appropriate calculations . For example, increasing DSO (taking longer to collect from customers) will increase the cash conversion cycle and tie up cash, reducing liquidity. Conversely, increasing DPO (delaying payments to suppliers) will free up cash and improve liquidity.
Other factors affecting working capital include:
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Seasonality of sales:Â Fluctuations in sales can cause variations in inventory and receivables, impacting working capital requirements.
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Business disruptions:Â Unexpected events (e.g., supply chain disruptions, natural disasters) can significantly affect working capital.
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Inventory changes: Changes in inventory levels have a direct effect on the liquidity position of a business .
3.3 Calculating Key Working Capital Metrics
Treasury professionals must be able to perform calculations of DSO, DPO, DIO, and the cash conversion cycle, and analyse the impact of changing them on the organisation’s cash requirements . This is a key skill for identifying areas for improvement and optimising the working capital cycle. The ACT’s DipTM syllabus reinforces this by requiring learners to “Critically assess accounts receivable, accounts payable, supply chain and inventory control in order to recommend how the organisation can optimise these processes” .