What is a Working Capital Cycle?
The Working Capital Cycle for a business is the length of time it takes to convert net working capital (current assets less current liabilities) all into cash. Businesses typically try to manage this cycle by selling inventory quickly, collecting revenue from customers quickly, and paying bills slowly, to optimize cash flow.
Steps in the Working Capital Cycle
For most companies, the working capital cycle works as follows:
- The company purchases, on credit, materials to manufacture a product (for example, they have 90 days to pay for the raw materials).
- The company sells its inventory in 85 days, on average (days payable outstanding)
- The company receives payment from customers for the products sold in 20 days, on average.
In the first step of the process, the company get the materials it needs to produce inventory but doesn’t initially have any cash expense (purchased on credit under accounts payable). In 90 days’ time, it will have to pay for those materials. Eighty-five (85) days after buying the materials, the finished goods are sold, but the company doesn’t receive cash for them initially (sold on credit under accounts receivable). Twenty (20) days after selling the goods, the company receives cash, and the working capital cycle is complete.
Working Capital Cycle Formula
Based on the above steps, we can see that the working capital cycle formula is:
Working Capital Cycle Sample Calculation
Now that we know the steps in the cycle and the formula, let’s calculate an example based on the above information.
- Inventory days = 85
- Receivable days = 20
- Payable days = 90
Working Capital Cycle = 85 + 20 – 90 = 15
This means the company is only out of pocket of cash for 15 days before receiving full payment.
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Positive vs Negative Working Capital Cycle
In the above example, we saw a business with a positive, or normal, cycle of working capital. Sometimes, however, businesses enjoy a negative working capital cycle where they collect money faster than they pay off bills.
Sticking with the above example, imagine now that the company decides to become a “cash only” business with its customers. By only accepting cash (no credit cards or payment terms), its accounts receivable days become 0.
Let’s use the same formula again and calculate their new cycle time.
- Inventory days = 85
- Receivable days = 0
- Payable days = 90
Working Capital Cycle = 85 + 0 – 90 = –5
Now, this means the company receives payment from customers 5 days before it has to pay its suppliers.
Financing Growth and Working Capital
Businesses with normal/positive cycles often require financing to cover the period of time before they receive payment from customers and clients. The is especially true for rapidly growing companies, and hence the idea that it’s possible to “grow the company out of money.”
To solve this problem, companies often arrange to have financing provided by a bank or other financial institution. Banks will often lend money against inventory and will also finance accounts receivable.
For example, if a bank believes the company is capable of liquidating its inventory at 70 cents on the dollar, it may decide to provide for 50% of the cost of the inventory (to give the bank a buffer in case the inventory has to be liquidated).
Additionally, if a company sells products to businesses that have high creditworthiness, the bank may finance those receivables (also called “factoring”) by providing early payment.
By combining one or both of the above two banking solutions, a company can reduce the capital required to finance their operations.
Working Capital Cycle in Financial Modeling
In financial modeling and valuation, one of the key set of assumptions that are made about a company is its accounts receivable days, inventory days, and accounts payable days.
When building a financial model, it is important to clearly lay out these assumptions and understand their impact on the business.
To learn more, check out CFI’s online financial modeling courses.
Thank you for reading this guide to understanding the importance of carefully managing a company’s working capital cycle.
CFI is the official provider of the Financial Analyst Certification in financial modeling and valuation. To advance your path towards this credential, these additional resources will be helpful: