As retail investors, we always discuss the returns generated by a company. In addition to the details of share price growth, few investors dig deeper into the revenues & profit margins growth generated by a company. However, most retail investors ignore one of the critical driving factors for any business. That is Working capital management.
In this article, we will understand the importance of working capital management in business and how can we choose the best stocks based on the efficiency in working capital for your investments.
Working Capital is the amount required to finance the day-to-day operations of any business.
Suppose a factory which manufactures two-wheeler motor vehicles. The company will generate revenues only when they sell the product. Based on the demand, the manufacturer has to purchase raw materials, manufacture the product and maintain inventory to make their product available to their customers. This process happens many times a year as a cycle. The amount required to finance all these related expenses is called Working Capital.
The cash conversion Cycle or Working Capital days is considered as the number of days it takes to convert its current assets and current liabilities into cash.
The formula to calculate Working capital Days is
Debtor Days + Inventory Days - Creditor Days.
Let's say, in the case of the two-wheeler manufacturer:
Debtor Days = 58
Inventory Days = 100
Creditor Days = 148
In this case, working capital days or cash conversion cycle is 58+100-148 =10 days.
The cash conversion cycle of 10 days means the company's cash is stuck in operations for 10 days.
Thus, a company's cash conversion cycle helps us choose the best company by enabling us to understand the efficiency of working capital management by a company and the negotiation power the company holds with its suppliers and customers.The cash conversion cycle also plays a crucial role in comparing companies with similar profitability and leverage ratios.
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