Running a business can be a bit like the art of spinning plates, requiring precise timing and careful planning. To keep operations moving, businesses need to balance the purchase of necessary materials with the generation of cash from sales – not only to earn revenue, but to pay suppliers. Without careful planning and timing, cash flow can falter, disrupting the delicate cycle of buying and selling.
By examining working capital – or the difference between current assets and liabilities – businesses can gain greater control over their financial affairs. This article explores the working capital cycle, shedding light on its role in improving cash flow and managing payments to suppliers and from customers.
What Is the Working Capital Cycle?
The working capital cycle (WCC) refers to the time it takes to turn net current assets and current liabilities into cash. In this context, “current” denotes assets a company plans to convert to cash, and liabilities that should come due within the span of one year. A long working capital cycle indicates a business’ capital is tied up for an extended period, delaying potential earnings. Conversely, shorter cycles signify a business can quickly free up cash, leading to a more agile and efficient cash flow.
Importance of the Working Capital Cycle
If every one of a business’ transactions occurred on the same day, it would be simple to understand the business’ financial position. In reality, there’s usually a delay between paying for assets, selling inventory or delivering a service, and receiving payment. This lag can lead to cash flow issues, underscoring the importance of managing the working capital cycle for better short-term liquidity and operational efficiency.
By examining working capital, or the difference between current assets and liabilities, businesses can gain greater control over their financial affairs.
Consider a furniture seller that spends $300 to manufacture a table. The longer it takes to sell the table, the longer it can take to recoup that expense and earn a profit. In the meantime, the business should find alternate funding to produce additional goods and pay for other liabilities – raw materials, debt, labor, utilities, etc. Commonly, the business may rely on payments received from prior sales to cover these costs. But this requires strategic management of accounts payable and accounts receivable; otherwise the business may not have enough liquid cash to meet short-term obligations and ensure uninterrupted operations.
How to Calculate Your Working Capital Cycle
To calculate the working capital cycle, it can be helpful to fully understand your current assets and liabilities. These figures inform four components of the working capital cycle.
- Cash: Monitoring both cash inflows and outflows affects the short-term financial health of a business. Cash is essential for maintaining the liquidity that current assets represent.
- Accounts Receivable: This reflects the company’s current assets and involves managing the payment terms extended to customers. Accounts receivable management can affect how long it takes the average customer to pay their bills, or how fast the company can convert receivables to cash.
- Inventory: Inventory is another key component of current assets. The rate of inventory turnover, indicated by the average number of days it takes to sell goods, can reveal how effectively a business can turn its inventory into sales, directly affecting cash flow.
- Accounts Payable: Strategically scheduling short-term liabilities, such as bill payments to suppliers, can help businesses hold onto liquid cash for longer. That cash on hand can be put towards other uses, such as building inventory or covering expenses.
Working Capital Cycle Formula
To calculate the working capital cycle, you can start with the average number of days it takes to sell inventory. Then add the average time a customer takes to pay their bill (receivable days) and subtract how long it takes the business to pay their suppliers (payable days).
The working capital cycle formula is:
Inventory Days + Receivable Days – Payable Days = Working Capital Cycle in Days
The working capital cycle formula may vary depending on the type of business. For example, a manufacturing business may have a more complex cycle than a retailer, as they may also need to factor in inventory holding periods for raw materials as well as finished products. This working cycle complexity is demonstrated in the second example below.
Working Capital Cycle Example
Let’s look at a simple working capital cycle for a hypothetical retailer, Supplies Ltd. The company buys products from a manufacturer. These products typically sell in six weeks, or 42 inventory days. As per a credit agreement with the manufacturer, Supplies Ltd has 60 days to pay its supplier, and when a sale is made, customer payment clears in three receivable days.
Because Supplies Ltd only stores and sells finished products, not raw materials or in-progress goods, their working capital cycle formula is relatively straightforward:
Inventory Days (42) + Receivable Days (3) – Payable Days (60) = -15 days
This negative working capital cycle (-15 days) means that Supplies Ltd is selling goods and receiving payments faster than it buys and pays for inventory. This means the retailer operates with a cash surplus that can be used for other operational activities or investments.
Note that this is a simple example, and some companies may have more complex working capital cycles. A business that makes furniture, for instance, may also need to consider factors such as how long raw materials are held before they're used in production, as well as how long it takes to create a finished product.
What Is a Positive Working Capital Cycle?
A positive working capital cycle is when a company has to wait to receive customer payments, creating a gap before available cash is on hand. This scenario is common, especially for businesses that offer customer credit terms. Businesses with a positive working capital cycle should carefully balance paying suppliers, creating their product or service, and receiving payments.
What Is a Negative Working Capital Cycle?
Not every business can achieve a negative working capital cycle. But for those that can, like in the Supplies Ltd example, collecting money faster than they can pay suppliers can lead to a healthy cash flow with less risk of a cash crunch. This is typically only possible for businesses with fast-paying customers and flexible supplier terms.
Why a Shorter Working Capital Cycle Can Be Good for Your Business
A shorter working capital cycle is useful because it lets businesses free up cash that would otherwise be tied up. In contrast, if the cycle is too long, the capital remains locked in the operational cycle without yielding any returns. It’s important for businesses to ensure they have enough capital from other sales or operations to bridge the gap and sustain itself until the cycle completes, thus avoiding cashflow problems.
How to Relieve Financial Pressure by Shortening Your Working Capital Cycle
A short working capital cycle is achievable in a number of ways. In most cases, it involves several factors in combination, such as:
- Handling inventory in a smart way. You can aim to buy stock at a good price and try not to hold too much at once. This can speed up inventory turnover, reducing the working capital cycle.
- Collecting on money owed. You can incentivize customers to pay early through early discounts, regular reminders, or decreasing credit terms. It can also help to proactively chase late payments.
- Paying bills on time, but not too early. Paying suppliers within their payment terms can help maintain rapport, avoid penalties, and keep a healthy credit rating. But there’s little benefit to your working capital cycle if invoices are paid earlier than they’re due. The longer you wait to settle invoices without paying late, the more you can reduce your working capital cycle.
The Takeaway
Despite best efforts, the working capital cycle can rarely be entirely within a business' control. Businesses can try to negotiate a favorable relationship with suppliers or incentivize customers to pay early, but working capital is often at the mercy of these external factors. By carefully applying the working capital cycle formula and understanding the results, business owners and financial professionals can better manage their cash flow and avoid cash crunches while they wait for inventory to sell and customers to pay.
A version of this article was originally published on August 9, 2022.
Photo: Getty Images
