5/26/23, 3:58 PM Understanding the Working Capital Cycle

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Working Capital Cycle

The length of time to convert net working capital into cash

Written by Jeff Schmidt

Published September 23, 2019
Updated May 11, 2023

What is a Working Capital Cycle?

The working capital cycle for a business is the length of time it takes to
convert the total net working capital (current assets less current
liabilities) 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.

Help
Steps in the Working Capital Cycle
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For most companies, the working capital cycle works as follows:

1. The company purchases, on credit, materials to manufacture a

product. For example, they have 90 days to pay for the raw materials
(payable days).

2. The company sells its inventory in 85 days, on average (inventory

days).

3. The company receives payment from customers for the products

sold in 20 days, on average (receivable days).

In the first step of the process, the company gets the materials it needs
to produce inventory but doesn’t initially dispense any cash (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
made and sold, but the company doesn’t receive cash for them
immediately, as they are sold on credit (recorded under accounts
receivable). Twenty (20) days after selling the goods, the company
receives cash, and the working capital cycle is complete.

Key Highlights

The working capital cycle for a business is the length of time it

takes to convert the total net working capital (current assets
less current liabilities) into cash.

The working capital cycle formula is Inventory Days +

Receivable Days – Payable Days

Sometimes a company will have a negative working capital

cycle. This can be a sign of efficiency in businesses with low
inventory and accounts receivable. In other situations,
negative working capital may signal a company is facing
financial distress if it doesn’t have enough cash to pay its
current liabilities.

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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 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

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This means the company receives payment from customers 5 days

before it has to pay its suppliers.

What is negative working capital?

Negative working capital is common in some industries, such as grocery

retail and the restaurant business. For a grocery store, customers pay
upfront, inventory moves relatively quickly, but suppliers often give 30
days (or more) credit. This means that the company receives cash from
customers before it needs the cash to pay suppliers. Negative working
capital is a sign of efficiency in businesses with low inventory and
accounts receivable. In other situations, negative working capital may
signal a company is facing financial trouble if it doesn’t have enough cash
to pay its current liabilities.

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. This is especially true for rapidly growing companies. A common
warning axiom regarding growth and working capital is to be careful not
to “grow the company out of money.”

To deal with this potential 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 be willing to provide a loan
equal to 50% of the value of the inventory (the 20% difference between
70% and 50% gives the bank a buffer, or financing cushion, 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 (called
“factoring”) by providing early payment of a percentage of the total
revenue.

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By combining one or both of the above financing solutions, a company

can successfully bridge the gap of time required for it to conclude its
working capital cycle.

Working Capital Cycle in Financial Modeling

In financial modeling and valuation, one of the key sets of assumptions
that are made about a company is in regard to 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.

Additional Resources

Analysis of Financial Statements

Valuation Overview

See all accounting resources

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