The working capital cycle describes the flow of money in a business, from its suppliers to its customers. It includes all the steps in the production process — buying raw materials, processing them, selling finished goods, and collecting payment for those goods.
Generally, shorter working capital cycles are better than longer ones. If a business can sell their inventory quickly, collect customer payments on time, and pay their vendors for raw materials slowly, they’ll have better cash flow. A long working capital cycle, on the other hand, ties up cash for a longer period of time without earning a return on it.
Read on to learn what the working cycle capital is, how it’s calculated, and the difference between a positive and negative working capital cycle.
Key Points
• The working capital cycle (WCC) refers to the time it takes for a business to convert its net working capital (current assets minus current liabilities) into cash./p>
• The three main components of the working capital cycle include the inventory period, the receivables period, and the payables period./p>
• A shorter working capital cycle is beneficial because it means the business is quickly converting its resources into cash, improving liquidity./p>
• Businesses can optimize their working capital cycle by reducing inventory holding periods, speeding up receivables collections, and negotiating better payment terms with suppliers to lengthen the payables period./p>
• If you’re struggling with a long working capital cycle and need cash to cover operative expenses, you can turn to a small business working capital loan or line of credit.
What Is the Working Capital Cycle (WCC)?
The working capital cycle is the amount of time it takes to convert net working capital (such as current assets and current liabilities) into cash.
The longer the cycle is, the longer a business is tying up capital in its working capital without earning a return on it. Therefore, companies generally strive to reduce the working capital cycle by selling inventory faster, collecting payment sooner, and/or stretching accounts payable.
Small business loans, including working capital loans, can help businesses meet their short-term needs while waiting to collect payment from customers.
Components of the Working Capital Cycle
There are four key components of the working capital cycle.
Accounts Receivable
Accounts receivable are the funds that customers owe your company for products or services that have been received and invoiced but not yet paid for. A company needs to collect its receivables in a timely manner so that it can use those funds to pay it debts and cover its operating costs.
Accounts Payable
Accounts payable is any money a company owes to its suppliers or vendors for goods or services received but not yet paid for. Businesses generally try to balance payables with receivables to maintain maximum cash flow. Often a company will delay payment as long as they can while still maintaining good relationships with suppliers.
Inventory
Inventory is the product (or products) a company sells and is its main asset. How quickly a company can sell and replenish its inventory is a key measure of its success. Generally, you want enough inventory that you don’t lose out on sales, but not so much that you are wasting working capital.
Cash
A business needs to generate enough cash from its activities so that it can meet its expenses and have enough left over to invest in infrastructure and grow the business. If a company doesn’t generate adequate cash to meet its needs, it may have trouble conducting routine activities, such as paying suppliers and buying raw materials, let alone making investments or handling emergency expenses. Working capital loans can help bridge this gap.
Working Capital Cycle Formula
The working capital cycle formula includes three factors:
• Inventory days: This refers to how quickly you can sell your stock. It includes the time you spend processing and manufacturing raw materials into products, as well as the time it takes to sell them to customers.
• Payable days: This is how soon you have to pay suppliers for the stock or raw materials.
• Receivable days: This is how long it is between selling your stock and receiving payment from customers.
To calculate the working capital cycle, you add the number of inventory days to your receivable days, and then subtract the number of payable days. The working capital cycle formula is:
Inventory Days + Receivable Days – Payable Days = Working Capital Cycle in Days
Calculating Working Capital Cycle
Here is an example of how to calculate the working capital cycle using a fictional business called Company ABC.
Company ABC follows this working capital cycle:
•
•
This number is how many days the business is out of pocket before receiving full payment, and is what’s known as a positive cycle.
Positive vs Negative Working Capital Cycles
| Positive Working Capital Cycle | Negative Working Capital Cycle | |
|---|---|---|
| Customers pay | Later | Up front |
| Need to pay vendors | Slowly | Quickly |
| Inventory moves | Later | Later |
| Receive cash before needing to pay vendors | No | Yes |
| Working capital cycle end number | Positive | Negative |
It’s normal for a business to have a positive working capital cycle and have a number of days where they are waiting for payment to give them available cash.
Companies that have a positive working capital cycle often need some type of business financing, such as a line of credit, invoice factoring, or accounts receivable financing, to hold them over until they receive payments from their customers and complete their working capital cycle.
A business with a negative cycle, by contrast, has collected money at a faster rate than they need to pay off their bills, which means the end number after using the formula is a negative number.
Negative working capital is common in some industries, such as grocery retail and the restaurant business. With these businesses, customers pay up front, inventory moves quickly, and suppliers often give 30 days credit. As a result, the business receives cash from customers before it needs to pay its suppliers.
Recommended: Understanding Working Capital Lines of Credit
Pros and Cons of Shorter Working Capital Cycles
| Pros of Shorter Working Capital Cycles | Cons of Shorter Working Capital Cycles |
|---|---|
| Frees up trapped capital | Negotiating better credit terms with suppliers can lead to higher unit prices |
| Can quickly turn stock into profit | May involve invoice financing and interest costs |
| Can invest in and grow your company without taking on debt | May need to be aggressive with account receivables |
The Takeaway
The working capital cycle is the time it takes to turn current assets into cash. There are three key factors that affect your working capital cycle: the time needed to pay your supplier, the time needed to sell your inventory, and the time needed to receive payment for your sales.
It’s normal for a business to have a positive working capital cycle, meaning there is a delay between being paid by your customers and needing to pay your vendors. Many small businesses rely on working capital loans, such as short-term loans, invoice factoring, and merchant cash advances, to bridge temporary dips in working capital.
If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.
FAQ
What are the 4 main components of the working capital cycle?
The four components of the working capital cycle are inventory, accounts receivable, accounts payable, and cash.
How is the working capital cycle calculated?
The formula for calculating the working capital cycle is:
Inventory Days + Receivable Days – Payable Days = Working Capital Cycle
Is the working capital cycle the same as the operating cycle?
Yes, the working capital cycle is also known as the cash operating cycle. Both terms refer to the number of days between paying suppliers and receiving cash from sales.
Photo credit: iStock/fizkes
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