All successful businesses have a functional working capital cycle. The working capital cycle is the time it takes for your business to turn money spent into cash available for use.
A strong cashflow is essential for a successful business. The longer your working capital cycle takes to process, the weaker your cashflow will be. Companies can manage their cycle by assessing each step, and finding solutions to any delays. This can be anything that speeds up their process, from selling more inventory, to shortening their payment terms and collect their funds sooner.
The three steps of the cycle are as follows:
There are plenty of factors that weigh in to delaying your revenue becoming available funds for use. These change depending on your industry, but the main elements of the cycle that can affect the time it takes for cash to become available are how long it takes to complete the work, and how long it takes to receive payment for said work.
For example, a wholesaling company can purchase stock and have it received within a week. They may expect to sell this stock within 6 weeks, although they may not receive payment immediately. Payment terms can be anything from 30 to 60 days, and the wholesaler still needs to pay the supplier for the purchased stock before their agreed payment term of 60 days is up.
To calculate the length of your cycle, you’ll need to use the working capital cycle formula. This is worked out by:
How long it takes to sell the inventory (Inventory Days) plus how long it takes to receive payment (Receivable Days) minus how long you have to pay your supplier (Payable Days) equals the length of your business’s Working Capital Cycle.
Using the formula above, the working capital cycle for the wholesaler is:
49 Inventory Days + 30 Receivable Days - 60 Payable Days = 19 Days Working Capital Cycle.
This number equates to how many days the business is awaiting their payment, and is what is known as a positive cycle.
Many businesses have positive working capital cycles, and have a period of time they are waiting for payment. If you have a negative cycle, it means you have collected payment sooner than when payment is due to your supplier, meaning your formula equates to a negative number.
An example of a negative working capital cycle could be:
21 Inventory Days + 30 Receivable Days - 60 Payable Days = -9 Days
Businesses will attempt to achieve a negative working capital cycle, as it will allow them to be paid for their sales before paying for the stock itself. This can be done by shortening payment terms from customers, or by lengthening their own payment terms.
There are plenty of simple ways to improve your working capital cycle, and therefore your cashflow. A positive cycle is not necessarily bad news, but you must be prepared, and have the available funds to pay for the purchased assets.
On paper, the solutions to a positive cycle are easy, reduce inventory days, reduce receivable days, and increase payable days.
Changing your payable days is the more difficult step, as other businesses are typically not keen to alter them. There are plenty of facilities that can be put in place to fix this, such as a revolving credit facility allowing you to delay payments up to 30 days.