How to improve your working capital cycle
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Keeping enough cash on hand to meet your day-to-day needs is an essential part of running your business. If you can’t balance the books and maintain sufficient working capital to operate smoothly from day to day, you’ll quickly face financial challenges.
In the worst case, your business may not survive if you don’t stay on top of the money coming in and out over a given period. That’s why it’s essential to understand the working capital cycle and bridge any gaps in your finances.
What is the working capital cycle?
Working capital cycle is the time it takes to convert net current assets into available cash, measured in days.
In other words, the period between buying raw materials and inventory and receiving payment from sales. The longer your working capital cycle days, the more time your money is tied up in products or materials, unavailable for you to spend on other things, like bills or other products.
A shorter cycle means you release cash faster and your business will be more agile and efficient. Let’s explore the concept in more detail, show how to calculate your working capital cycle, and see how short-term financing can be used strategically to place your business on a stronger footing.
There are four main elements in a working capital cycle that you need to keep a close eye on:
- Available cash – this is the working capital to support day-to-day needs. A healthy cash balance means successfully managing your business’s cash inflows and outflows to make sure you have enough on hand to meet your needs.
- Receivables – the payment process and terms for the goods and services that you supply.
- Inventory – your stock and other components that support it. How long is capital tied up in stock before it is sold?
- Billing – How long do you have to pay your suppliers?
To calculate the working cycle formula, add the number of inventory days to receivables days, then subtract the number of payable days. Thus:
Inventory days + receivable days - payable days = working capital cycle days
How the working capital cycle impacts your business
Don’t underestimate the importance of the working capital cycle. Cash flow, liquidity, and long-term financial stability depend on a working capital cycle that doesn’t stretch your business and leave it short of money.
The longer your working capital cycle, the more difficult it is to have good cash flow. And good cash flow is the lifeblood of every business.
While it’s normal for businesses to have some days when they are waiting for payments to replenish their coffers (a period known as a positive working capital cycle) long gaps can leave businesses exposed. For example, you may not be able to buy new stock or pay staff if you have all your capital tied up in products that are yet to sell.
Conversely, if you have a negative cycle, you have collected money more quickly than you need to make payments, so there will be a minus figure (ie, negative) at the end of the working cycle formula instead of a plus figure. With a negative working capital cycle, you are more operationally efficient and in a better cash position to meet day-to-day expenses.
How to calculate your working capital cycle
Now that we know the formula, let’s show an example using the working capital cycle calculation:
- 50 inventory days
- 25 receivable days
- 55 payable days
Thus: 50 + 25 - 55 = 20 working capital cycle days
20 represents the number of days the business must draw on its available cash before receiving payment.
A negative cycle might be as follows: 30 days to sell your inventory, 25 days to receive payment, and 50 days to pay what you owe.
Thus: 30 + 25 - 60 = minus 5 working capital cycle days
Working capital cycle example
For manufacturers, the working capital cycle is likely to be a little more complex than for retailers, as retailers don’t need to stock raw materials which they must turn into finished products.
Here’s a typical working capital cycle calculation for a furniture manufacturer:
- The manufacturer sources raw materials from a supplier
- The supplier’s terms are 60 days
- The manufacturer holds the materials for around 20 days before production (the inventory period)
- Production takes around 10 days
- The finished product is held in stock for around 30 days
- Retailers who buy the furniture pay, on average, after 50 days
The formula would look like this:
Inventory period (20) - trade payable days (60) + holding time for production (20) + finished product holding time (30) + trade receivables days (50).
20 - 60 + 10 + 30 + 50 = 50
What is a good working capital cycle?
The definition of a ‘good’ working capital cycle will vary by industry and sector, so it is important to seek the optimal working capital cycle for your specific business. This will depend on your typical operating cycle, meaning the number of days between spending money on inventory and receiving income from goods or services.
If you run a retail business that has heavy seasonal demands, you must ensure you have sufficient working capital to maintain inventory for the months ahead. In the meantime, before you recoup capital outlay from expected sales, you will have ongoing expenses that cut into your cash reserves. Therefore, the shorter the working capital cycle, the better for the business.
In contrast, if you were a software supplier that operates purely online and sells non-physical products that are downloaded, you wouldn’t have the same inventory requirements and pressure on working capital.
Key working capital cycle metrics
Here are some familiar terms relating to working capital cycle and business KPIs.
- Inventory turnover ratio – this is a measure of how quickly inventory stock is sold and replaced over a given time. It is calculated by dividing the cost of goods by the average inventory over the same period. A high ratio is a positive performance indicator.
- Days sales outstanding (DSO) – DSO records the average number of days to collect payment following a sale. A low DSO indicates efficient receivables.
- Days payable outstanding (DPO) – DPO records the average number of days it takes to pay a supplier. Companies with higher DPOs hang on to cash longer than companies with lower DPOs.
How to improve your working capital cycle
There are a variety of ways to improve your working capital cycle, some of which will make more sense at times than others. Managing your working capital cycle will likely require a combination of different techniques at different times – for example, if you have a busy season approaching, minimising inventory may not be an option, so it may make more sense to seek short term financing to tide you over.
Minimise inventory levels
Selling your inventory as soon as possible and avoiding stockpiling will reduce costs. If stock is taking a long time to sell, focus on ways to improve your marketing and sales strategies, and reduce inventory management through techniques such as just-in-time, where goods are received from suppliers only when needed.
Accelerate receivables
To accelerate receivables, consider shortening your invoice time, perhaps offering discounts for early payers, and improving credit control by clearly communicating your payment terms and conditions.
Ensure you invoice as soon as the product or service has been provided, and follow up immediately with a reminder if the due date has passed. Automating credit control will speed up receivables.
Optimise payments
This is more difficult than accelerating receivables, but you could try to negotiate better supplier terms to retain cash in your business as long as possible, or seek a credit arrangement. Cash flow modelling can help you estimate future inflows and outflows of cash and provide insights to optimise payments. To maintain a good credit score, pay your suppliers on time but don’t pay earlier than necessary.
Consider financing options
There are a number of options that can ease cash flow. For example, invoice factoring and invoice finance enable you to collect invoice payments upfront without waiting for the client to pay.
Trade credit, a B2B credit agreement that enables you to buy goods and pay later, is another financing option, while business overdrafts are a traditional means of accessing additional funds.
What are working capital loans?
Loans can be an important safety net for businesses that need to fill cash flow gaps and maintain sufficient working capital. With iwoca, you can quickly secure a working capital loan to cover your everyday expenses, with decisions in as little 24 hours with our SME-focused Flexi Loan.
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