Working Capital Need & Working Capital Cycle
1. What is Working Capital?
Working Capital refers to the short-term funds required by a business for its day-to-day operations — such as buying raw materials, paying wages, and covering overheads until cash is collected from customers.
Formula:
Working Capital = Current Assets – Current Liabilities
In banking, we calculate the Working Capital Gap (WCG) to understand how much external funding (loan) is needed.
2. Example – Mr. Ravi's Organic Soap Unit
- Own capital: Rs. 12 lakh
- Used for machinery & setup (fixed assets): Rs. 8 lakh
- Remaining cash: Rs. 4 lakh
Business Operations:
- Raw material per batch: Rs. 6 lakh (1 month stock)
- Manufacturing time: 20 days
- Customer payment cycle: 45 days
- Supplier credit: 15 days
3. Timeline of Cash Flow
- Day 0: Buys raw material (Rs. 6 lakh) on 15-day credit
- Day 20: Manufacturing completed
- Day 25: Goods sold
- Day 70: Customer pays after 45 days
4. Working Capital Cycle (WCC)
Formula:
WCC = Inventory Period + Receivables Period – Payables Period
Calculation:
WCC = 20 + 45 – 15 = 50 days
Mr. Ravi needs funds to manage operations for these 50 days until customer payment is received.
5. Working Capital Requirement
- Monthly Working Capital Need: Rs. 6 lakh
- Annual Turnover: Rs. 72 lakh
- Required Limit: (50/360) × 72,00,000 = Rs. 10 lakh approx.
6. Mistakes to Avoid
- Ignoring the Working Capital Cycle
- Assuming timely customer payments without agreement
- Overestimating supplier credit duration
7. How to Reduce Working Capital Requirement?
- Negotiate longer credit terms with suppliers
- Reduce stock holding period (improve turnover)
- Push customers for faster payment (shorten receivables)
8. Summary Table
| Component | Days |
|---|---|
| Inventory Holding | 20 |
| Debtor Collection | 45 |
| Creditor Payment | 15 |
| Working Capital Cycle | 50 |
Always align your working capital funding with your actual operating cycle — not just with estimated sales.
Understanding When Working Capital Requirement Arises
A business often faces financial stress not due to losses but because of the **timing mismatch** between paying for purchases and receiving money from sales. This delay is known as the Working Capital Cycle. It defines how long your money is tied up in operations before you get it back as cash.
The Business Scenario
Let us take a fictional example to understand this process: A business starts with Rs. 10 lakhs of its own capital. On Day 0, it purchases stock worth Rs. 7 lakhs (on credit), and uses Rs. 3 lakhs to pay other expenses. The goods are sold in 30 days, but payment from customers (debtors) is received only after 60 days.
Timeline Overview
- t = 0: Purchased stock worth Rs. 7L (on credit); capital: Rs. 10L.
- t + 30 days: Sold stock, paid creditors Rs. 5L (partial), and booked new stock of Rs. 7L (but don’t have funds).
- t + 60 days: Received Rs. 14L from debtors (sales), paid old creditors, and booked new stock again.
Where the Business Gets Choked
At the end of the first 30 days, the business is stuck. It has sold goods, but the money from debtors is still pending (receivable in 30 more days). Meanwhile, it needs to:
- Pay creditors partially or fully (Rs. 5L)
- Buy fresh stock for the next order (Rs. 7L)
Since cash hasn’t come in yet, the business either:
- Brings in fresh capital (by selling jewellery, property, etc.)
- Or takes short-term unsecured loans
Balance Sheet Snapshots
Through each stage, the balance sheet changes but the cash crunch remains due to:
- Debtors (Rs. 14L)
- Stock (Rs. 7L)
- Creditors (Rs. 5L)
Key Takeaway
The first working capital cycle is the toughest. After that, the business becomes self-sustaining if profits are retained. However, **bank finance can ease the transition** and avoid disruptions. Short-term unsecured loans used in early stages can later be replaced with formal **working capital limits** like CC, OD, or WCDL.
Conclusion
Working capital finance is not only for loss-making businesses. Even a profitable firm can get stuck if money is tied up in inventory and receivables. Bankers and entrepreneurs must identify this timing mismatch early and provide or seek timely support.