The working capital cycle

The Working Capital Cycle, also known as the Cash Conversion Cycle (though sometimes slightly different), is a metric that measures the time it takes for a company to convert its investments in inventory and other resources into cash from sales. It tracks the flow of cash tied up in the business's short-term operations.

It represents the average number of days between paying suppliers for raw materials or inventory and receiving cash from customers after selling the finished goods or services. It essentially measures how long a business's cash is tied up in its operational processes.

The key components are typically measured in days:

• Days Inventory Outstanding (DIO) / Inventory Conversion Period: The average number of days inventory is held before being sold.
• Days Sales Outstanding (DSO) / Receivables Collection Period: The average number of days it takes to collect payment from customers after a sale.
• Days Payables Outstanding (DPO) / Payables Deferral Period: The average number of days a company takes to pay its suppliers.

A common formula for the Working Capital Cycle (or Cash Conversion Cycle) is:

Working Capital Cycle = DIO + DSO - DPO

To calculate the components in days, you often need: Cost of Goods Sold, Sales Revenue, Accounts Receivable, Inventory, and Accounts Payable figures from the financial statements, along with the number of days in the period (e.g., 365).

Calculate each component in days first:

• DIO = (Average Inventory / Cost of Goods Sold) * Number of Days
• DSO = (Average Accounts Receivable / Total Credit Sales) * Number of Days
• DPO = (Average Accounts Payable / Cost of Goods Sold) * Number of Days (Sometimes Total Purchases is used if COGS isn't available for this purpose)

Then, use the formula: WCC = DIO + DSO - DPO.

Generally, a shorter Working Capital Cycle is better. A shorter cycle means the business is converting its inventory and receivables into cash more quickly, improving liquidity and potentially reducing the need for short-term borrowing. However, what constitutes a "good" cycle varies significantly by industry. Some industries naturally have longer cycles than others (e.g., manufacturing vs. retail).

To shorten the cycle, a business can:

• Reduce DIO: Improve inventory management, speed up production.
• Reduce DSO: Speed up collection of receivables (e.g., offer early payment discounts, improve credit terms).
• Increase DPO: Negotiate longer payment terms with suppliers without damaging relationships.

Yes, a negative Working Capital Cycle is possible and often indicates a very strong cash management position, particularly common in industries like fast-food or retail. It means the company is receiving cash from customers (sales) *before* it has to pay its suppliers for the goods sold (i.e., DPO is greater than DIO + DSO). This effectively means suppliers are financing the company's operations.

Inventory directly impacts the DIO (Days Inventory Outstanding) component of the Working Capital Cycle. Higher inventory levels or slower inventory turnover increase the DIO, which lengthens the Working Capital Cycle, tying up cash for longer periods. Efficient inventory management is key to shortening the cycle.