Working Capital CycleDefinition & How to Calculate!

We’ve all heard the expression that “cash is king” and this not only holds true in our personal lives but in the business world as well.

Without enough cash, businesses can run into some major troubles, or worse be forced into bankruptcy.

Cash helps businesses stay liquid and gives them opportunities for investing in new infrastructure or deal with unexpected expenses.

Running a business is complex.

You need to pay your vendors and employees but in order to do so, you need to generate cash in order to make these payments.

This is where the working capital cycle formula comes into play.

A businesses working capital cycle is the length of time it takes to convert net working capital, like current assets and liabilities, into cash.

This article is going to cover the key aspect of the working capital cycle and why it is a key formula for gaining control over your assets and liabilities.

What is the Working Capital Cycle?

As mentioned above, the working capital cycle is the length of time it takes a business to convert net working capital, like current assets and liabilities, into cash.

There are typically two types of working capital cycles:

• Long cycles which means your capital is tied up for longer periods of time without earning a return.
• Short cycles, which means you are able to free up cash faster with a quicker turnaround time.

Because businesses are so complex with many moving parts, it is virtually impossible to have all of your transactions occur on the same day or period.

At any given time you will have accounts payable due, perhaps payments on a loan, employee salaries, inventory, account receivables, and more.

Managing your working capital cycle help improve your liquidity cycle, meaning that you can convert your assets and liabilities in a more efficient way, giving your business more liquidity and stability.

Four Phases of the Working Capital Cycle

There are generally four phases to the working capital cycle:

1. Cash management – making sure that there is a positive inflow and outflow of cash to manage the business.
2. Receivables – these are the payment terms on money owed for goods and services.
3. Inventory – How long is it taking to sell your inventory?
4. Payables (billing) – These are your payables to your suppliers, vendors, etc.

In order to use the working capital cycle formula, you need to know the Inventory days, Receivable Days, and Payable days.

This is why we have the four phases listed above.

Here is an example of how a company may follow the working capital cycle:

1. The company purchases supplies and materials needed to manufacture they products. These purchases are made on credit and thy have 90 days to pay for the materials (Net 90). This is your “Payable Days.”
2. The inventory sells in an average of 85 days which is called “Inventory Days.”
3. Customers pay for the products sold within 20 days on average. This is your “Receivable Days.”
4. Once the customer receives Cash payment from their customers, the working capital cycle is complete.

Now, let’s put this all together into the working capital cycle formula.

Working Capital Cycle Formula

The working capital cycle formula is as follows:

Working Capital Cycle = Inventory Days + Receivable Days – Payable Days

Let’s plug the above example into the formula to calculate the working capital cycle:

• Inventory Days = 85
• Receivable Days = 20
• Payable Days = 90

Working Capital Cycle:

85 Inventory Days + 20 Receivable Days – 90 Payable Days = 15

What this means is that the company is out of pocket cash for only 15 days before receiving payment in full.

This also means that the company has a positive working capital cycle.

Positive vs Negative Working Capital Cycle

A positive working capital cycle means that the company has a period of time where they are waiting to receive payment to create available cash.

This is very normal and in the above example, the company waits an average of 15 days to receive payments to create available cash.

However, there are instances when a company may have a negative working capital cycle.

What this means is that they are collecting money faster than they are paying their bills off.

Let’s use the same example as above but now instead of accepting credit card payment terms, the company decides to be a cash only business with its customers.

Accepting cash only brings its Receivable Days to zero.

Let’s put this all together in a formula and see what we get:

• Inventory Days = 85
• Receivable Days = 0
• Payable Days = 90

Working Capital Cycle:

85 Inventory Days + 0 Receivable Days – 90 Payable Days = -5

Because this gives us a negative number, the Working Capital Cycle is telling us that this business receives cash payments from customers 5 days before it has to pay its vendors and suppliers.

Working Capital and Growth

Companies that have a normal or positive working capital cycle often need financing to holed them over until they receive payments from their customers.

In the positive working capital cycle example above, this company has 15 days where they are waiting to receive payment from customers.

Growing companies could run into issues if they do not have backup financing because they could essentially “grow the company out of money.”

During the gap when a company is waiting to receive cash, they may have other vendors to pay which could lead to a shortage of cash.

By combining cash and some sort of financing, companies are able to bridge the gap and still meet their obligations during periods that they are waiting to receive cash and complete their working capital cycle.