The Working Capital Cycle can be used as a tool to help a business calculate how fast it turns net working capital into cash (current assets less current liabilities), and subsequently book a profit. Working Capital Cycle can be calculated using the below formula:
Working Capital Cycle = Inventory days + Receivable days – Payable days
The Working Capital Cycle allows you to predict how long it will take for you to be paid in full, and how long you might be out of pocket. A positive Working Capital Cycle means that there will be a period before your business receives payment from customers. Some businesses may enjoy a negative working capital cycle where they collect money faster than they pay off bills.
By knowing your business’ Working Capital Cycle, it can help you better manage cash flow, inventory, and operational efficiency. Ultimately help your businesses turn a profit. Let us break this down further.
Inventory days simply refers to the average time it takes to sell your inventory. As inventory may be your primary source of revenue, it is important to know when your business will generate income.
Inventory Days = (Cost of Average Inventory / Cost of Goods Sold) x 365
Receivable days refers to the average time it takes for you to be paid by your customers once an invoice has been issued. There is not an absolute number of accounts receivable days that is considered representative of excellent or poor accounts receivable management, as the value varies considerably between industries and the underlying payment terms.
Receivable Days = (Accounts Receivable / Annual Revenue) x 365
Payable days refers to the average time it takes for you to make payment to creditors which include suppliers, vendors or other companies.. A company with a higher value of Payable Days takes longer to pay its bills, which means that it retains available funds in the business for a longer duration.
Payable Days = (Accounts Payable / Cost of Goods Sold) x 365
How to Improve the Working Capital Cycle
To improve your Working Capital Cycle to help businesses turn a profit, here are a couple of tips.
Decrease Inventory Days
By avoiding stockpiling, your business can decrease inventory days. Your business may look into adopting a just-in-time inventory system where inventory arrives ‘just-in-time’ as when needed. It is worth noting that some businesses may choose to have high inventory days so that they can provide a short turnaround time to deliver goods to their customers.
Reduce your receivable days
Implement an active collection process to ensure your business is able to collect payments on time or even earlier. Alternatively, utilise an invoice financing facility that allows businesses to convert their accounts receivables (i.e. outstanding invoices) into cash in as little as 24 hours.
Stretching your payable days
Try renegotiating your payment terms with your suppliers to:
- Extend payment terms
- Pay in instalments over a period
- Request for more favourable payment terms in exchange for a longer sales contract