The Working Capital Cycle

Wed, Oct 28, 2020

The working capital cycle is a measure of how much cash a business needs to generate its sales. It is generally comprised of three parts.

Payable days – how long the business takes to pay its suppliers.

Inventory days – how long the business holds goods/WIP before making a sale.

Receivable days – how long the business takes to get paid by its customers.

Working capital days = Inventory days + Receivable days – Payable days.

If a business has a positive working capital cycle then the more it grows, the more funds it will need to raise to support that growth.

It is possible to have a negative working capital cycle – famously, Amazon receives money from customers as they pay. Their suppliers hold the stock for them and then Amazon hold on to the income for a few weeks before making deductions from suppliers and paying them their share. This means the more they grow the more working capital is in their business.

You will see a variety of different formulas to calculate these metrics, some are over simplified. Here’s our recommendations:

Receivables days = (Month end receivables / (GROSS sales for the last quarter x 4)) x 365

Payable days = (Month end payables / (GROSS (Stock related COGS* + overheads – salary costs) for the last quarter x 4)) x 365

Inventory days = (Month end inventory held / (NET COGS* for the last quarter x 4)) x 365

*COGS = Cost of Goods Sold

Where we refer to Gross/Net, this is because it’s important to compare like-for-like. Your receivables and payables would be included in the balance sheet gross of VAT, whereas inventory would not have VAT added, also the numbers in your P&L are net of VAT.

With software like Xero, you can get the information by filtering a receivables/payable invoice detail report. Commonly the formulas ignore VAT so that they can compare global companies for investment purposes but that’s not relevant for small businesses. If you are not registered for VAT then this point is irrelevant.

Tracking these KPIs monthly will give a good steer on how the business is performing. It’s important to delve into the underlying reasons, for example increasing payables days can be good if your suppliers are extending you additional credit, or very bad if it’s just because you don’t have the cash to pay your suppliers.

The metrics can also be used to formulaically project working capital requirements in budgets and forecasts.