Running a business often feels like spinning plates. You need to pay suppliers to produce your product or service, but require sales to generate cash to make payments. It’s a catch-22 that can make all the difference to your cashflow.
In this article, we’ll explain what Working Capital Cycle means and how, by weighing your current assets and liabilities, you can help your business by having greater control over your affairs, letting you navigate every business landscape.
What is the Working Capital Cycle?
If every transaction involved in your business could magically occur on the same day, it would be super simple to understand the company’s financial position at any moment in time. However, in reality, there’s almost always a delay between paying for assets, selling inventory or delivering a service, and receiving payment for your goods or work.
The amount of time that passes between using your cash to purchase stock and ultimately receiving money for the sale is called the Working Capital Cycle.
How to calculate your Working Capital Cycle
Let’s calculate the Working Capital Cycle for a fictitious manufacturing company.
The formula to calculate the Working Capital Cycle for this company is:
This means Maker Ltd will be out of pocket for an average of 64 days between paying its supplier, producing and shipping the product and receiving cash into its bank account from customers.
Now let’s see what the Working Capital Cycle is like for a retailer. The formula is simpler because a retailer doesn’t need to hold raw materials in stock and turn them into a product.
Supplies Ltd buys furniture from Maker Ltd which they expect to sell in six weeks’ time (Inventory Days). They have 60 days to pay their supplier Maker Ltd (Payable Days), and when a sale is made, payment arrives into their account in three days (Receivable Days).
The working capital formula is:
Inventory Days + Receivable Days - Payable Days = Working Capital Cycle in Days
In our example:
Inventory Days (42) + Receivable Days (3) - Payable Days (60) = A Working Capital Cycle of -15 days
The number of days that comprise the Working Capital Cycle is how long the business is out of pocket before receiving payment in full for its inventory. If the number is above zero, it’s a positive cycle. If it’s less than zero, it’s negative.
Why a shorter Working Capital Cycle can be good for your business
When a company is waiting to receive payment to create available cash, it has a positive Working Capital Cycle. This is normal and the situation most businesses are in because they must balance paying suppliers with producing their product or service, and being paid.
However, (as we saw in the retailer example above) it is possible to have a negative cycle if you’re able to collect money faster than the time you require to pay your bills. In this case, the cycle is a negative number, like this:
20 Inventory Days + 3 Receivable Days - 30 Payable Days = -7 Days
A shorter Working Capital Cycle is useful because it lets you free up cash for use elsewhere that would otherwise be stuck in the cycle. In contrast, if your cycle is too long, the capital remains locked in the operational cycle without giving any returns. It’s important to remember that while cash is locked in the cycle, the business needs to have enough capital to sustain its operations, otherwise it could fall into debt and face cashflow problems.
How to relieve pressure on your business by shortening your Working Capital Cycle
If you have a shorter Working Capital Cycle, it’s probably due to several factors in combination.
- You handle your inventory in a smart way. You buy stock that’s in demand at a good price and don’t hold too much at once.
- You’re efficient at collecting the money you’re owed. Perhaps you incentivise customers to pay earlier and proactively chase late payments.
- You’re nailing sales. Your marketing and sales departments are keeping fresh orders flowing in so you can clear stock and issue invoices sooner.
- You’re paying your bills on time, but not too early. It’s important to pay your suppliers within their payment terms to stay on good terms and keep your credit rating healthy, but there’s little benefit to your Working Capital Cycle in paying invoices earlier than they’re due. The longer you have to pay suppliers, the shorter your cycle will be.
Despite your best efforts, your Working Capital Cycle will rarely be entirely within your control. For instance, although you can try to negotiate a favourable relationship, you can’t dictate your suppliers’ payment terms.
To help maximise your cashflow, meet your obligations, and take only smart risks to pursue growth opportunities, you could consider an American Express® Business Card, which gives you up to 54 day payment terms.
In the case of the manufacturing company we looked at earlier, instead of paying the supplier within 45 days using cash, you could pay them a few days before their invoice is due using your Business Card, then have an additional 54 interest-free days to clear the card balance using cash.
To maximise the payment period to the full 54 days, you need to spend on the first day of the new statement period and repay the balance in full on the due date. To use a Business Card to extend your Working Capital Cycle, you should line up your supplier payments with your preferred statement cycle. That way, you could have business receivables coming in before business expenses are going out.
Find out more about American Express Business Cards.