These Ratios Help You Understand the Working Capital Cycle
There are many financial ratios and key performance indicators that can help you manage your business. So many that a small business owner could tie themselves up for days calculating and annualizing the various performance indicators. But suppose your business is profitable but has been experiencing cash flow difficulties. In that case, the underlying reason is likely to be found in one of those ratios. And that crucial ratio is the working capital cycle.
What is the Working Capital Cycle?
The part of the equation missing from the working capital calculation is timing. You need to know how long it takes for the cash you use to produce products or render services to reappear as cash you can spend in your bank account. And that’s where calculating the working capital cycle can help you manage your working capital.
To calculate the working capital cycle (also known as the cash operating cycle), you add the inventory days to the receivables days and deduct the payables days. The components of that equation, each of which is a valuable efficiency indicator, are calculated as follows:
Inventory days indicate how long it takes you to turn over your inventory. The ratio is calculated as follows: (Average Inventory x 365) / Annual Cost of Sales.
Receivable days show how long, on average, your customers take to pay their sales invoices. This ratio is calculated as follows: (Average Receivables x 365) / Annual Credit Sales.
Payables Days estimates the average number of days it takes you to pay suppliers and is calculated as follows: (Average Payables x 365) / Annual Credit Purchases.
Related Article: How Much are Your Accounts Receivable Costing You?
How to Interpret the Working Capital Cycle?
What does the working capital cycle ratio tell you about your business? Here is a simple example of what the ratio means for your cash flow.
Suppose a company buys products for resale on 30 days credit. Then, those items sit in inventory for a further 40 days before they are sold. And the company grants its customers 45-day credit terms. In that case, the company is tying up cash for: (Inventory Days + Receivables Days – Payables Days) or (40+45-30), or 60 days.
Related Article: How to Manage and Control Your Cash Flow
How Can You Shorten the Working Capital Cycle?
Once you understand the working capital cycle and its importance to cash flow, it is relatively easy to see how to shorten the cycle. The ratio also highlights the importance of monitoring the efficiency ratios of inventory days, receivables days, and payables days.
To reduce the working capital cycle and improve cash flow, you must reduce the amount of time working capital is tied up in non-cash current assets:
Extend AP Credit Terms
You can shorten the working capital cycle by negotiating better credit terms with your suppliers. There might be a trade-off needed to achieve this, though, in higher unit prices. Even so, the increase in the price of raw material or goods for resale would likely be offset by lower finance costs and greater flexibility in your cash flow.
If you have been paying vendors early to collect early settlement discounts, you might want to reconsider this policy, too. Again, the extra cost of not collecting settlement discounts would be offset by the savings on finance costs like overdraft interest. And, if cash flow shortages have become critical, the extra cost is unlikely to be as damaging as having crucial supplies cut off because of non-payment of vendor invoices.
Reduce Inventory Cycles
Optimum inventory levels vary by industry. However, if you have significant levels of stock in hand at any time, that will be tying up cash. So, operating a leaner stock-holding policy would reduce the working capital cycle and improve cash flow.
The best place to begin reducing inventory is with a detailed analysis of inventory usage forecasts. Once you estimate how much of each item you will use over time, you can calculate inventory days for each stock item. And then you can cut back on the purchasing of slow-moving items and, possibly, move to a just-in-time purchasing model.
Collect Cash from Receivables Faster
Suppose accounts receivable appears to be the underlying cause of an extended working capital cycle. In that case, you might need to review your credit terms and collection procedures.
The credit terms you grant customers will be dictated to a certain extent by the standard terms in your industry. So, do some research to discover if you have been overly generous with credit. You should also check how closely your receivables days ratio matches your standard terms. If your receivables days ratio comes at 90, and your terms are 30 days, you have an AR collections issue to address.
If customers are, in the main, paying invoices in accordance with your terms, outsourcing your accounts receivable would be another way to shorten the working capital cycle. If you factored your sales invoices, you could receive the bulk of the cash within a day or two of issuing the invoices.
There is, of course, a cost to sales invoice factoring. However, the financing cost of factoring is usually comparable to that of running an overdraft. You would also free up the cash currently tied up in unpaid sales invoices.
Related Article: Ten Benefits of Invoice Factoring for Small Businesses
The Bottom Line
Monitoring the profitability of a business is, of course, crucial for success. But managing working capital and cash is equally essential. And the abovementioned efficiency ratios will help you understand where cash is tied up. So, if your company is showing healthy profits but cash is tight, start by calculating the working capital cycle and see how that has changed over time. Because shortening that cycle will result in more money in the bank.
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Universal Funding is a nationwide invoice factoring solutions leader, supporting growth-focused businesses with scalable factoring solutions. With its invoice factoring, payroll funding, and purchase order financing services, Universal Funding provides clients with the working capital needed to grow and support their businesses without taking on new debt. Ranked as one of the nation’s top invoice factoring companies, Universal Funding provides cash flow financing for businesses all across the United States.