Your working capital cycle explained in 4 simple steps
Understanding the working capital cycle formula and how to use it.
The world of business can be loud and busy. So busy in fact that it’s easy to get overwhelmed by the noise of it all. The one thing that you can be sure of hearing above all the noise is the word profit.
Chances are you started your business to fulfill a purpose, a vision, a dream. But to keep doing that, your business needs to make a profit. The good news is that you can work out how fast your business can turn a profit very easily by using the working capital cycle formula. Never heard of the working capital cycle formula? Well, stick around to find out why we think it’s worth a closer look.
The working capital cycle formula enables you to measure how fast your business can turn its current assets into money in the bank (your working capital cycle). It’s a magic trick that lets you to see into the future. A finance crystal ball, if you will.
When you know what your working capital cycle is, you can predict how long it will take for you to be paid in full, and how long you might be out of pocket. With this information, you can better manage your cash flow, inventory, and efficiency.
Let’s start by looking at the formula:
Working capital cycle = inventory days + receivable days – payable days
That seems pretty complicated, so let’s simplify…
Step 1: Inventory days
The first thing you need to do is get to know your inventory. Inventory is your stock, goods and other contents of your business. Your inventory days refer to the time it takes, on average, to sell your inventory.
Let’s pretend that you make metal straws (thank you for helping to save the environment by the way). We’ll call this business The Metal Straw Co. Now let’s pretend that it takes you about 80 days to sell a batch of stock. That means that you’re working with 80 inventory days.
Step 2: Receivable days
Now that you’ve produced and sold your stock, you need to be paid. Your clients, also referred to as your debtors, take 21 days to pay you for the order of straw that you’ve invoiced. In other words, you’re working with 21 receivable days.
Step 3: Payable days
Next, we need to look at your payment practices. How long does it take you to pay your suppliers (also referred to as your creditors) for the raw materials used to make the metal straws? In this example, we’ll say that it takes 90 days for you to pay your suppliers. So, you’re working with 90 payable days.
Step 4: Working capital cycle
Now that we have all the parts, we can work out your working capital cycle. Let’s put them into the formula:
80 inventory days + 21 receivable days – 90 payable days = a working capital cycle totalling 11 days
So what does this mean?
As we mentioned before, the working capital cycle formula tells you how many days it takes for your business to turn your working capital into cash. It gives you that crucial glimpse into the future. In this example, it takes a total of 11 days for The Metal Straw Co. to turn their current assets into money in the bank.
Now what? If you want to improve your working capital cycle, you already have all the information you need…
You can improve your working capital cycle by:
- Reducing your receivable days, i.e. getting your debtors to pay you faster.
- Stretching your payable days so you can have favourable payment terms.
- Managing your inventory days by avoiding stockpiling and getting your products to move faster.
- Making sure that your receivable days are not greater than your payable days. i.e. ensuring that you get paid by your debtors before you need to pay your suppliers.
It’s not always possible to negotiate shorter payment terms with your debtors – especially if you’re working with big blue chip companies. Your receivable days might be 30, 60 or even 90 days, which has a huge impact on your working capital cycle.
With invoice finance, a finance provider (like MarketFinance) will give you an advance against your outstanding invoices. This means that you can get up to 90% of that working capital upfront, without having to wait for your debtors to pay. You can advance against some, or all, of your invoices, depending on your needs.
Click here to find out more about invoice finance from MarketFinance.