The working capital cycle is the amount of time it takes for a company to convert its investments in inventory and other short-term assets into cash.
In other words, it is the time it takes from the moment a company purchases inventory until the moment it receives payment from its customers.
The working capital cycle can be a helpful metric for evaluating a company’s efficiency and financial health. A shorter working capital cycle indicates that a company is able to quickly turn its inventory into cash, which can be used to pay down debts or reinvest in the business.
A longer working capital cycle, on the other hand, may indicate that a company is struggling to generate enough cash flow to cover its expenses. As a result, companies with long working capital cycles may be more likely to default on their debts or face other financial difficulties.
Given the importance of the working capital cycle, it is not surprising that analysts and investors often closely monitor this metric when considering whether to invest in a particular company.
It takes your business more time to get a healthy cash flow if your working capital cycle is long. Business cycles are often managed by revising each step if possible. In order to achieve this, you might sell inventory faster, collect payment sooner, and pay bills later.
The cycle involves three major steps:
- Pay for assets (for example inventory to sell or equipment for a job).
- Sell inventory (or complete the job for a customer).
- Receive payment on what you’ve sold (funds now available to pay costs).
What affects the working capital cycle?
Depending on your industry, the length of the working capital cycle will be influenced by how long it takes you to sell your stock and when you receive payment.
In one example, a manufacturing company buys raw materials from its supplier on credit, anticipating selling the product to a customer in eight weeks. The manufacturer must still pay the supplier before their 60-day credit payment terms expire, since payment from the client may not come immediately – say, another 30 days.
Working Capital Cycle Formula
The working capital cycle formula, also known as the cash cycle formula, is used to calculate the length of your cycle, or your working capital days. The Working Capital Cycle is essentially: the amount of time it takes for your business to sell the inventory (Inventory Days) plus the amount of time it takes to receive payment (Receivable Days) minus the amount of time it takes to pay your suppliers (Payable Days).
Given the preceding example, the manufacturer has a 26-day working capital cycle:
56 Inventory Days + 30 Receivable Days – 60 Payable Days = 26 days working capital cycle.
The number represents how many days the business is out of pocket before receiving full payment, which is what’s known as a positive cycle.
Positive cycle vs negative cycle
It is perfectly normal for businesses to have a positive working capital cycle and to be waiting for payment for a number of days before they have access to the cash they need.
In a negative cycle, a business collects money faster than it needs to pay off its bills, so the end number is a negative number.
You could have a negative cycle where your inventory sells in 25 days, you receive payment in 20 days, and you pay off your credit card bill in 60 days:
25 Inventory Days + 20 Receivable Days – 60 Payable Days = -15 days
In order to create a negative working capital cycle, many businesses move inventory faster, shorten customer payment terms and extend their own terms of payment.
To increase a positive working capital cycle you could introduce a supplier early payment discount, in order to turn the cycle against the negative effect.
Improve the working capital cycle and grow your business
Despite the fact that a negative cycle is desirable, it’s perfectly normal for businesses to be in a positive working capital cycle and have a period of time where cash is scarce. Even so, you can still continue to grow your business if this is the case for you.
Keeping your cash flow as high as possible is possible by managing each step of the cycle. The reduction of inventory days, the reduction of receivable days, and the increase in payable days are also simple to understand.
- Your first priority should be to sell your inventory as soon as possible and reduce the time it stays on hand. In addition, you will be able to avoid stockpiling and save some money on storage.
- Invoice management could be a powerful tool for reducing receivable days. Improve your credit collection process by shortening invoice terms and offering early supplier discounts. Invoice finance is a popular method to bring forward the revenue you’re due within a few days of raising the invoice.
- Changing the payable days is the step that is most difficult to change in the cycle. You might be able to lengthen their credit terms by negotiating with your suppliers. It is also possible to seek alternative methods like a business credit card to cover your costs, but it’s vitally important to be aware of the extra costs you may incur, thus impacting your working capital cycle in a way you weren’t anticipating.
Seasoned professional with a strong passion for the world of business finance. With over twenty years of dedicated experience in the field, my journey into the world of business finance began with a relentless curiosity for understanding the intricate workings of financial systems.