In the sometimes-lengthy process of turning a product into capital, all businesses are subject to what is called the “working capital cycle” (WCC). The working capital cycle is the amount of time it takes for a business to pay off their liabilities, such as their suppliers, and then begin collecting all cash they receive from sales as profit within one operating cycle. A well-managed working capital cycle often reflects a well-managed business. Businesses with working capital cycles with too many operational stopgaps can lead to low liquidity and a less stable production line. Effectively managing your company’s working capital cycle can give massive insight into your own operations and can better inform your financial decision-making.
Elements of a Working Capital Cycle
A working capital cycle can be separated into three categories, often called Accounts Payable Days, Inventory Days, and Accounts Receivable Days:
Accounts Payable Days: A business purchases raw materials for manufacturing and has a certain number of days to pay suppliers. The number of days in which you must pay your suppliers are your “Accounts Payable Days.”
Inventory Days: A business sells that inventory made from those raw materials to customers over a certain number of days. However many days it takes to sell your inventory are your “Inventory Days.”
Accounts Receivable Days: A business receives payment from customers over a certain number of days via invoice or credit card. The number of days you must wait for invoices and credit charges to become capital are your “Accounts Receivable Days.”
The basis of a good working capital cycle is making sure accounts receivable and inventory days are few enough so you can still pay suppliers on time. A working capital cycle can also be written as the formula:
Inventory Days + Receivable Days – Payable Days = Working Capital Cycle
Positive Working Capital Cycle
In most working capital cycles there are more accounts payable days — the days where payments from clients come in — than inventory and receivable days. This can be due to invoices or credit card processing windows that can take up to several weeks to become capital. Working capital cycles where payable days outnumber the sum of inventory days and receivable days are called positive working capital cycles.
Positive Working Capital Cycle Example: A CD manufacturing company takes 80 days to sell their available inventory during an operations cycle and then takes 45 days for credit card payments and invoices to become capital. The company also has 45 days to pay their suppliers for the raw materials, so their working capital cycle takes 80 days and is positive.
80 Inventory Days + 45 Accounts Receivable Days – 45 Accounts Payable Days = 80-Day Working Capital Cycle
Negative Working Capital Cycle
Despite its name, negative working capital cycles are often anything but a negative impact on a business’s operations. If your business has no gap between when inventory is sold in exchange for hard capital, they very likely would run a negative working capital cycle. The most traditional example of negative working capital cycle businesses are those that only accept cash. A business that deals solely in cash and has no invoices would have a zero Accounts Receivable Days meaning it is possible Accounts Payable Days may be greater than Inventory Days, leading to a negative working capital cycle.
Negative Working Capital Cycle Example: A local farmers market takes 30 days to sell all of their available inventory during one operations cycle. The farmers market only accepts cash and has no invoices. Since the farmers market has all capital on-hand at the point of sale, they have 0 Accounts Receivable Days. The farmers market takes 45 days to pay for raw materials and liabilities, meaning their working capital cycle takes -15 days.
30 Inventory Days + 0 Accounts Receivable Days – 45 Accounts Payable Days = -15-Day Working Capital Cycle
Improving Working Capital with Tactical Financing
One of the most frustrating parts of business operations is waiting for invoices to cash after making a sale. The 30, 60 or even 120 days necessary for invoices to become capital will take a massive toll on a company’s working capital cycle. That number of days is a business’s “Accounts Receivable Days” and by shortening the amount of time an invoice is in limbo, a business can massively improve their working capital cycle.
Invoice factoring is an agreement between a business and lender where the business sells unpaid invoices to a lender who then pays approximately 95% of the invoice’s value up front. In most invoice factoring agreements, it is then up to the lender to collect on the original invoice. When the client’s invoice eventually clears, the lender, or factor, will send a final percentage of the invoice to the business while usually keeping a 3% fee for the transaction.
By expediting the time an invoice takes to become capital, a business can massively increase their cash flow and in turn improve their working capital cycle. There are, however, counterexamples where an invoice factoring agreement may extend a working capital cycle. If an invoice factoring agreement allows for business recourse, then the business, not the lender, is responsible for invoices that go unpaid. This can also be the case if a factoring company is unable to collect, or has a difficult time collecting on an invoice. In these cases, it could be a while until you get that last percent from your invoices. If you would like to learn more about invoice factoring and other working capital loan options, please see Kapitus’s comprehensive guide detailing the several working capital loans options for small businesses.
Shortening Your Working Capital Cycle
Without becoming a solely cash business there are several strategies to shortening a working capital cycle to increase cash flow.
Reevaluate Manufacturer Options: When was the last time your business checked your supplier’s competition? Depending on your business and operation cycles there are likely several optimizations to your business which could effectively reduce Inventory Days. Is it possible to buy your most frequently used materials in bulk? Have you considered working with emerging manufacturing hotspots like Malaysia or Indonesia? Sit down with your team and think creatively about how your business can take advantage of rising globalism and manufacturing options to keep inventory turnover and quality high. Keep an eye out for local manufacturing options alternatives as well.
Renegotiate Existing Deals: Most modern operation cycles require several cultivated relationships with manufacturers and liveries which should be regularly assessed to make sure your business is getting the best deal possible. When your business buys raw materials from a supplier, how long is your credit period? That credit period is the same as your business’s Accounts Payable Days and by expanding the number of days your business must pay back suppliers in, your working capital cycle will shorten as well.
Kick Up Accounts Receivables Collection: There are several other ways to speed up accounts receivables collection without invoice factoring or financing. By shortening the amount of time between a sale and when that sale becomes liquid your business’s cash flow and working capital cycle will both improve. Consider making an updated A/R Aging Report which consolidates all of company’s accounts receivables data into one place for easy consideration and optimization. Does your business offer payment plans for high-volume purchases? A great way to attract new clients and boost monthly receivables is to offer structured payment plans. Another strategy to maximize your business’s accounts receivables is to increase your client base.
Final Considerations and the Nature of the Working Capital Cycle
Barring very specific industries, having a positive working capital cycle is a good indicator that a business is financially sound. Regarding growth, however, it is often difficult for companies to expand when their operational cycles leave low liquidity and high asset value. This is why several businesses seek financing from banks or private lenders to cover working capital and in turn reinvest in their own operations.
There is no universally ‘good’ working capital cycle because every business’s operations cycle is different. If your business has several long-term invoices, invoice financing could be a great way to kick up your working capital cycle. If your slowdown is on the manufacturer’s side however, you will need to consider wholly different solutions.
If you would like to learn more about your business’s working capital cycle financing options, please get in touch with a Kapitus financing expert who can address your unique situation.