The working capital cycle is an important financial concept for businesses that sell products to customers. It helps you understand how long your money will be tied up in stock and inventory. The working capital cycle can be used together with your cash flow statement to predict how money flows in and out of your business, as well as ensure you have enough cash-on-hand to meet your commitments.
We know you’ve got questions about the working capital cycle, and we’ve got the answers. Read on to find out how to calculate your working capital cycle and how to optimize it for business survival and growth.
What is the Working Capital Cycle?
The working capital cycle tells you how quickly you’re turning business assets, like inventory, into cash in your bank account. Understanding your working capital cycle means you’ll know exactly how long your money is tied up in stock, and how soon you’ll have access to money for operational needs or to grow your business. The working capital cycle is normally expressed in days, and the shorter the cycle, the more efficient your business is at managing finances.
Why is the Working Capital Cycle Important?
Businesses rely on having a free cash flow—enough cash-on-hand to meet their operational costs like paying staff, taking care of bills, and buying more stock for the future. Understanding this cycle lets you predict how quickly you’ll get money into your business so you can budget and plan properly.
What Are My Business Assets?
The assets that matter are those that you’ve spent money on with the intention of reselling to make more money. You also need to take account of your liabilities—so your net assets are your current assets less your current liabilities.
What’s the Difference Between Assets and Liabilities?
- Assets are what your business owns.
- Liabilities are what your business owes.
You deduct your liabilities from your assets to create your net assets. You don’t actually use this figure to calculate the length of the working capital cycle, but it’s very useful to understand how much money you have sitting in disposable assets at any time. Here’s an example:
- You buy stock to the total value of $20,000 from your supplier, the money you owe to the supplier is a liability of $20,000.
- You plan to sell the stock to customers for a total of $45,000, the stock you own is an asset worth $45,000.
- Your assets for the purpose of calculating your working capital cycle are $45,000 less $20,000 for a total of $25,000.
How quickly you can turn that $20,000 into $45,000 is your working capital cycle.
What is the Working Capital Cycle Formula?
The working capital cycle is based on three main factors:
- How quickly you can sell your stock, known as “Inventory Days.”
- How soon you have to pay suppliers for the stock or raw materials, known as “Payable Days.”
- How long it is between selling your stock and receiving money from customers, known as “Receivable Days.”
The working capital cycle formula is: Inventory Days + Receivable Days – Payable Days.
Your inventory days aren’t necessarily just the amount of time you have a product in stock before it’s sold. If you’re a manufacturing or another more complex business, it also includes the time you spend processing and manufacturing raw materials into products plus the time it takes to sell them to customers.
For example, if it takes you 60 days to sell stock to customers, you need to pay your suppliers within 30 days, and it takes another 20 days to receive payments from customers, your working capital cycle would be:
60 (Inventory Days) + 20 (Receivable Days) – 30 (Payable Days) = 50 days for your working capital cycle.
In some cases, a business may collect money from sales before it needs to pay for the stock. In those cases, the working capital cycle can actually be a negative number of days.
How Do I Calculate My Business’s Working Capital Cycle?
Working capital cycles can be as broad or as detailed as you want. Start from the perspective of “Does this give me the right level of information to understand my overall cash flow and working capital?”
- A straightforward retail business that sells a few different types of products might just want to use a broad average for the calculation.
- A manufacturing business with different durations for paying suppliers, manufacturing products, and receiving money from buyers might have a different working cycle calculation for each product.
Once you know the right level of detail for you to make smart financial decisions, you can calculate your working capital cycle. Let’s assume you just want a simple calculation.
- Use your stock management, accounts payable, and accounts receivable details to understand how long things take.
- Accounts payable will tell you approximately how soon your suppliers expect payment after providing you with goods or materials. That’s your Payment Days.
- Stock management will tell you how long it takes to process, manufacture, and sell your stock to customers. That’s your Inventory Days.
- Accounts receivable will tell you how quickly you get final payment from customers. That’s your Receivable Days.
Then, simply use the formula above to calculate the working capital cycle.
How Do I Shorten My Working Capital Cycle?
The shorter your working capital cycle, the more quickly you’re able to turn stock into profit, which is better for your finances and operating expenses. There are several ways to shorten the cycle.
Increase the Amount of Time You Have to Pay Suppliers
Most suppliers will extend credit to you for a certain period before they require you to pay them. For example, a supplier may require payment within 30 days. See if you can negotiate longer payment terms with your suppliers. You may need to commit to certain minimum requirements like order quantities and values.
Process, Manufacture, and Sell Your Stock More Quickly
The shorter your inventory time, the better. If you have a processing and manufacturing period, do what you can to shorten the process while maintaining quality. If you’re holding stock, identify trends such as seasonal variation to minimize the time your money is tied up in inventory.
Get Money from Customers Faster
The last part of the puzzle is to get customers to pay you sooner. You could offer shorter terms of payment on your invoices, or provide a discount or other incentives for paying quickly.
Invoice Factoring, Accounts Payable Financing, and Lines of Credit
Finally, there are some specialist financial services that can provide you with operational cash prior to your working capital cycle completing:
- Invoice factoring and accounts receivable financing will shorten your Receivable Days by providing cash advances based on your outstanding invoices or accounts to be paid.
- Lines of credit are a short-term solution to free up cash within your business and are best used to shorten your Inventory Days.
These financing options can charge higher amounts of interest and fees, so you will need to balance that cost against your need to have operational funds more quickly.
As you calculate and streamline your working capital cycle, you’ll increase the financial efficiency of your business. This will give you the funds you need to comfortably manage cash flow and redirect money to operational costs and expansion.