Calculate the Working Capital Cycle for your business
Whether you know it or not, your business has a working capital cycle. This is the term given to the time it takes for your business to turn net current assets into available cash.
The longer the working capital cycle, the more time it takes for your business to get cash flow positive. It’s common for businesses to manage their cycle by revising each step where possible. This could be by selling inventory quicker, collecting payment sooner, or paying bills later.
There are three main steps in the cycle:
1) Pay for assets (for example inventory to sell or equipment for a job)
2) Sell inventory (or complete the job for a customer)
3) Receive payment on what you’ve sold.
What affects the working capital cycle?
Factors will vary between industries, but essentially how long it takes you to sell your inventory and how long it is before you receive payment will impact the length of the working capital cycle for your business.
Looking at a simple retail business, the cycle starts with purchasing stock to sell – you may be paying on account (and deferring payment) or paying cash (so up front). The cycle ends when the stock is sold to your end customer and the money appears in your bank account.
In another example, a manufacturing company purchases raw materials on credit from their supplier for a product which they expect to sell in eight weeks' time to a client. Payment from the client, however, may not come immediately - say, another 30 days - and the manufacturer still needs to pay the supplier before their credit payment terms of 60 days are up.
Working capital cycles can become much more complicated, particularly when international trade or complex supply chains are involved.
Working Capital Cycle Formula
To calculate the length of your cycle, you'll need to use the working capital cycle formula. In a nutshell, this is: how long it takes to sell the inventory(Inventory Days) plushow long it takes to receive payment(Receivable Days)minushow long you have to pay your supplier(Payable Days) equalslength of your business's Working Capital Cycle.
Using the example above, the working capital cycle for the manufacturer is 26 days:
56 Inventory Days + 30 Receivable Days - 60 Payable Days = 26 daysworking capital cycle.
This number is how many days the business is out of pocket before receiving full payment, and is what's known as a positive cycle.
Positive cycle vs negative cycle
For once, in finance, being negative is a good thing when it comes to the working capital cycle.
It's perfectly normal for most businesses to have a positive working capital cycle and have a number of days where they are waiting for payment to give them available cash.
A business with a negative cycle has collected money at a faster rate than they need to pay off their bills, which means the end number after using the formula is a minus number.
A negative cycle for a retailer might be 25 days to sell your stock, 2 days to receive payment but 30 days to pay off credit:
25 Inventory Days + 2 Receivable Days - 30 Payable Days = -3 days
Many businesses strive for a negative working capital cycle by trying to move inventory at a faster rate, shortening customer payment terms and lengthening their own payment terms.
Improve the working capital cycle and grow your business
Understanding your working capital cycle is key when it comes to managing the cash flow of your business – and we all know how crucial cash flow is for small business owners.
So what can you do to improve it once you’ve worked it out?
1) Reduce inventory days – in many industries, stockpiling is seen as a bad indicator of business performance. While we can’t all practice Just In Timemanufacturing or management, there are steps you can take to reduce inventory and stock so you hold onto it for less time. In addition to shortening the working capital cycle, this can potentially reduce storage costs.
2) Reduce receivable days – better credit and invoice management can reduce the time taken for your customers to pay. Early-bird discounts, shortened invoice terms and better debt chasing can help. Another option would be to pull revenue forward by using an invoice factoring facility. With factoring, a finance provider will provide you with the majority of your invoice value (typically up to 90% or more) within a day or two of the invoice being raised. The remainder, less the factoring fee, is sent on to you when the customer pays.
3) Increase payable days – this can be difficult, but you may be able to increase your payable days, perhaps by negotiating better credit terms with your suppliers or by using a credit card to pay. Be careful, however, of increasing your overall costs.
It might sound relatively academic, but managing your working capital cycle is an important skill when it comes to running your business.
