What is the Working Capital Cycle? Simple Definition, Formula, Examples and Importance
Working Capital Cycle Definition
The working capital cycle is the time it takes for a business to convert its inventory into cash, which is then used to cover expenses.
It serves as an important metric that measures the efficiency of a business’s operational and financial activities.
The working capital cycle is often also called the cash conversion cycle.
The typical step-by-step flow of the working capital cycle looks like this:
Purchase of Inventory or Raw Materials
The working capital cycle typically begins with the business using cash to buy inventory or raw materials needed for the production of goods or services.
Production of Inventory (if applicable)
The raw materials are then used in the production process, resulting in the creation of finished goods available for sale.
This step is not applicable if the business just purchases inventory that is already available for sale.
Sales (including credit sales if applicable)
If the business makes sales on credit, goods or services are sold to customers where payment will be made at a later date.
Consequently, the accounts receivable totals increase.
Accounts Receivable (if sales are made on credit)
The time it takes for customers to pay their invoices is a critical element of the working capital cycle.
The business needs to manage its accounts receivable efficiently to ensure prompt payments are receivable, and minimise the possibility of bad debts occurring.
Cash Collection
The working capital cycle continues with the collection of cash from customers.
This could be through cash sales or through payments for goods and services initially sold on credit.
Accounts Payable
If the business has purchased raw materials or incurred expenses on credit, it will have an accounts payable balance.
This represents the amount that the business owes to suppliers.
The business therefore uses its cash reserves to settle accounts payable, which completes the working capital cycle.
Return to Purchasing Inventory or Raw Materials
The working capital cycle now restarts as the business uses its available cash to purchase inventory or raw materials, and the process repeats.
Working Capital Cycle Formula
The working capital cycle formula is:
Working Capital Cycle = Inventory Days + Receivable Days − Payable Days
Where:
Inventory Days
This measures how long it takes for a company to turn its inventory into sales.
A lower inventory days number indicates that inventory is not held for long periods.
Receivable Days
This measures how long a company takes to collect payment from credit sales.
A lower receivable days number indicates quicker cash conversion from credit sales.
Payable Days
This measures how long a company takes to pay its suppliers.
A higher payable days number allows a company to hold onto its cash for longer, which helps the liquidity of a business.
How to Calculate Working Capital Cycle
To further help our understanding of the working capital cycle, let’s look at a real-world example:
A business has the following:
Inventory Days | 30 days |
Receivable Days | 30 days |
Payable Days | 45 days |
Using the working capital cycle formula:
Working Capital Cycle = Inventory Days + Receivable Days − Payable Days
Working Capital Cycle = 30 days + 30 days – 45 days
Working Capital Cycle = 15 days
This means that the business takes, on average, 15 days to convert its current assets into cash.
Interpreting the Working Capital Cycle
Now we understand the theory, and how to calculate the working capital cycle, we need to understand what the actual results mean to a business.
After calculating the working capital cycle, the result will either be positive or negative:
Positive Working Capital Cycle
A positive working capital cycle means that the business has to wait for payments to be received in order to generate cash.
This is how most businesses operate and is a completely normal situation.
Businesses would naturally prefer a lower working capital cycle, as this indicates that the business can generate cash faster, which reduces the need to borrow money externally.
However, if the working capital cycle is too low, it could imply that the business is not buying sufficient amounts of inventory or providing favourable credit terms to its customers.
This situation may lead to potential issues, such as insufficient stock levels, reduced sales opportunities, and a negative impact on profitability.
Negative Working Capital Cycle
A negative working capital cycle might sound problematic at first, but is actually a good sign for a business.
It effectively means that a business can pay their suppliers before they need to receive payments from customers.
This is a good position to be in, as it would indicate the business has a cash surplus, and enables them to use the spare cash in other areas, such as investing in growth opportunities such as research and development, increased marketing budgets, capital expenditure or acquiring rival businesses.
Comparisons vs Industry
It is important to note that comparisons of the working capital cycle work best between businesses in the same industry.
This is because different industries have different operational dynamics and therefore meaningful comparisons cannot be drawn.
For example, manufacturing companies may have longer working capital cycles due to the time it takes to produce, distribute, sell, and collect payments for physical products, compared with a software company that sells digital products.
Comparing the working capital cycle of a business with the industry average, or a competitor within the same industry, can provide useful insights into the performance of the business.
A higher working capital cycle might suggest that the business takes longer to convert their inventory into cash, potentially indicating inefficiencies in inventory management or delayed customer payments.
A lower working capital cycle might suggest that the business has a competitive advantage in managing their working capital.
This would mean they quickly turn inventory into cash, which could indicate effective inventory turnover and prompt collections from customers.
Importance of the Working Capital Cycle
Effective management of the working capital cycle is important for several reasons:
Cash Management
Optimising the working capital cycle is critical to ensure that a business has the sufficient cash available for normal operations.
This involves managing the timing of cash inflows and outflows to make sure that the cash coming into the business is sufficient to cover the cash flowing out of the business.
For example, a business is owed £200,000 from a customer and receives the payment on time.
They then use that £200,000 to purchase more inventory to be sold, and pay staff salaries and other business expenses.
If that £200,000 payment wasn’t received on time, the business wouldn’t have the cash needed to replenish stock and cover their business expenses.
This could then force the business into financial difficulty or even administration.
Cost Reduction
Shortening the time it takes to sell inventory (ie to convert it into cash) and collect receivables promptly, reduces the need for the company to take on debt, which saves costs on interest payments.
For example, a manufacturing business can minimise the costs of holding inventory by efficiently moving products quickly from production to sales.
Similarly, a business that collects receivables promptly from customers can avoid unnecessary costs from having to take out debt to cover operational expenses during periods of delayed payment.
Business Growth
Business with a shorter working capital cycle often experience increased growth as they are able to reinvest more quickly.
For example, imagine a business that, through efficient management of their inventory, receivables and payables, can channel all available cash into research and development or marketing promotions.
This ability to reinvest quickly can lead to growth, increased profitability and a competitive edge in the market.
How to Improve the Working Capital Cycle
Let’s now look at methods and strategies that could be used to improve and optimise the working capital cycle:
Inventory Management
Inventory management is another important component in the working capital cycle, as it directly affects the cash conversion process.
Think about a business that is carrying too much stock. They would be tying up capital and running the risk that the stock becomes outdated or obsolete.
On the other hand, think about a business that has too little stock. This can result in lost sales and damage to customer relationships.
In order to strike the optimal balance, a business could implement demand forecasting techniques using historical sales data and market trends, to predict the ideal levels of stock thorough the year.
Optimising inventory levels using these insights means that the business can avoid overstocking and ensures that products are readily available for sale.
Where possible, a business could implement a just-in-time inventory system to reduce storage costs.
A just-in-time inventory system is an inventory management approach where inventory is ordered and received only when needed in the production process.
This approach minimises holding costs and improves operational efficiency.
Favourable Credit Terms
Businesses should look to negotiate favourable credit terms with suppliers to improve their working capital cycle.
Negotiating favourable payment terms with supplier could involve:
- Extending the payment period: for example, moving from 30 day payment terms to 60 day terms.
- Discounts for early payments: for example, a 5% discount if the invoice is paid within the first 10 days
- Flexible payment terms: for example, splitting the payment into manageable chunks over a set period of time.
Effective Credit Control
Businesses should encourage prompt payments from customers and proactively chase any debts outstanding to minimise the chance of bad debts.
This can be achieved through:
- Thorough credit assessments: to make sure that credit is offered to suitable businesses in the first instance (ie with a good credit history).
- Regular monitoring of customer accounts: frequent analysis of customer payment behaviour, to allow any potential issues to be proactively resolved.
- Active communication: for example, sending friendly payment reminders well before the due date to encourage timely payments.
- Offering incentives and penalties: for example, discounts for early payments and late fees for overdue amounts.
Streamlined Processes
Efficient, streamlined processes can significantly contribute to an improved working capital cycle by reducing the time taken to convert assets into cash.
Consider a furniture manufacturing business that turns raw materials into household items.
If the production process is completed in 2 days rather than 5, the business has the opportunity to potentially sell the item 3 days earlier, resulting in faster cash flow.
To make the manufacturing process more efficient, a business could:
- Optimise production lines: for example, reorganising workflows to minimise bottlenecks
- Upgrade equipment: upgrading equipment can lead to improved precision, speed, and reliability, which can contribute to higher output and lower production costs.
- Implement automation tools: for example, using robotics and software solutions to handle repetitive and time-consuming tasks.
- Enhance staff training: skilful and competent staff can operate equipment more efficiently and troubleshoot issues more effectively.
Analysing Individual Components
The end calculation of the working capital cycle formula should not be just used in isolation.
As there are three components that make up the working capital cycle, each one should be analysed individually, to ensure that any problems in each of these areas are highlighted.
For example, imagine the below situation in a business:
Inventory Days | 40 days |
Receivable Days | 10 days |
Payable Days | 45 days |
Using the working capital cycle formula:
Working Capital Cycle = Inventory Days + Receivable Days − Payable Days
Working Capital Cycle = 40 days + 10 days – 45 days
Working Capital Cycle = 5 days
This means that the business takes, on average, 5 days to convert its current assets into cash.
In contrast to our initial example above, this illustration seems more favourable, comparing a 15-day working capital cycle to a 5-day outcome.
However, this business is holding onto inventory for an extra 10 days compared to the first example, which may indicate declining sales (as more stock is being held onto for longer).
Despite the adverse increase in inventory days, a significantly more favourable receivable days number compensates for this.
This could indicate that the credit control at the business is extremely efficient, possibly due to lots of customers taking up an early payment discount option.
It is for this reason that all components should be evaluated, alongside the overall working capital cycle outcome.