Working capital and the cash conversion cycle

In short

A friend of mine ran a small hardware store for twenty years, and he used to say that the bank balance and the profit report never told the same story. If you own a business, you have probably felt that gap yourself. Working capital is the money tied up in the daily running of the shop. The cash conversion cycle counts how many days that money stays stuck before it comes back. Both numbers come from the balance sheet and income statement that a business already keeps. A shorter cycle is better, because every day cut loosens cash without a loan. Checking the figures once a quarter and writing them down shows the trend. Small habits build large comfort.

The whole of it

What it is

I once watched a baker explain to her nephew why she was always short on cash during her busiest month. She had bought flour and butter in bulk, baked all week, and sold on credit to two restaurants that paid thirty days later. Her sales were up and her wallet was thin. That puzzle is what working capital is about.

Working capital is current assets minus current liabilities. Current assets are things a business owns that it can turn into cash within a year. They include cash, money customers still owe (accounts receivable), and goods waiting to be sold (inventory). Current liabilities are bills due within that same year. They include bills to suppliers (accounts payable), short term loan payments, and taxes due soon. Subtract the second from the first and the result is working capital.

The cash conversion cycle is a cousin of that idea. It measures time rather than dollars. It counts the days between paying for goods and collecting cash from the customer who bought them. A short cycle means money comes home quickly. A long one means money is out working for a long while, and the owner is the one waiting on it.

The split between current and long term items comes from standard accounting practice. The Financial Accounting Standards Board sets the rules for how a balance sheet separates the two in its Accounting Standards Codification. Under those rules, current means due or expected to turn into cash within one year, or within the business's normal operating cycle if that is longer.

How it works

If you have ever made a big sale and still felt short on cash, you know cash does not move at the speed of a sale. The business buys goods, they sit on a shelf, and then they sell. The customer may pay right away or weeks later. Each of those pauses ties up money.

The cycle has three pieces. Days inventory outstanding is how many days goods sit before they sell. Days sales outstanding is how many days customers take to pay after they buy. Days payables outstanding is how many days the business takes to pay its own suppliers. The cycle is the first plus the second, minus the third.

Here is the logic in plain terms. The first two pieces are waiting time that hurts the owner, since money is stuck in goods or in unpaid invoices. The third piece is waiting time that helps, since the supplier carries the cost for a while. So the goal is to sell goods faster, collect faster, and pay on the due date. Not early. Not late.

A cycle can even be negative. That happens when a business collects from customers before it has to pay its suppliers. A grocery store can come close to that, because shoppers pay at the register and the store pays for the goods later.

The numbers, and where to find yours

If you keep books for a business, you may be glad to hear that every number needed is already sitting in two reports. Current assets, current liabilities, inventory, receivables, and payables come from the balance sheet. Sales and cost of goods sold come from the income statement. Cost of goods sold is what the business paid for the items it actually sold during the period.

The formulas run like this. Working capital equals current assets minus current liabilities. Days inventory outstanding equals inventory divided by cost of goods sold, times 365. Days sales outstanding equals receivables divided by sales, times 365. Days payables outstanding equals payables divided by cost of goods sold, times 365. Then the cycle equals the first, plus the second, minus the third.

If you keep books in software, those balance sheet lines are one click away. If a bookkeeper or tax preparer helps you, ask for the balance sheet and income statement for the same year. A federal income tax return also carries related figures. The IRS publishes instructions for each business return, such as Form 1120 for corporations and Schedule C for sole proprietors. Those instructions explain how cost of goods sold is figured and how inventory is reported. Lenders often look at these same lines when a business asks for credit. Knowing your own figures helps you see what they see. Whole year figures, or a steady twelve month stretch, keep a seasonal rush from bending the answer.

A worked example

A neighbor of mine named Marcus owns a small shop that sells bike parts and repairs, and his numbers make a good story. Last year his sales came to $400,000. His cost of goods sold was $250,000. At year end his balance sheet showed $20,000 in cash, $30,000 in receivables, and $60,000 in inventory. That makes current assets of $110,000. He owed $25,000 to suppliers and $15,000 in other short term bills and loan payments. That makes current liabilities of $40,000.

His working capital is $110,000 minus $40,000, which is $70,000. That looks healthy. But the days tell the fuller story.

Days inventory outstanding is $60,000 divided by $250,000, which is 0.24. Then 0.24 times 365 is about 88 days. His parts sit on the shelf nearly three months.

Days sales outstanding is $30,000 divided by $400,000, which is 0.075. Then 0.075 times 365 is about 27 days. Customers, mostly local teams and a few businesses, take almost a month to pay.

Days payables outstanding is $25,000 divided by $250,000, which is 0.10. Then 0.10 times 365 is about 37 days. He pays suppliers in a bit over a month.

His cycle is 88 plus 27 minus 37, which is 78 days. For about eleven weeks, his money is out of reach after he buys a part.

Now suppose Marcus trims his slow movers and cuts inventory from $60,000 to $50,000. That is $50,000 divided by $250,000, which is 0.20. Then 0.20 times 365 is 73 days. His cycle drops to 73 plus 27 minus 37, or 63 days. He freed $10,000 in cash without a loan or a single new sale. That is the whole point.

Where it goes wrong

I have made this mistake myself, and you may have too. It is trusting profit as if it were cash. A business can show a profit and still miss payroll, because the profit is tied up in shelves and unpaid invoices.

The second trap is stretching suppliers too far. Paying late can lift the payables days on paper, but it can cost a business good terms, late fees, or a supplier's trust. The seller may refuse to ship, or the contract may charge interest on overdue balances. A cheap trick can get expensive.

I once walked into a shop that had trimmed its stock so far that the shelves were bare, and that is the third trap. A customer who cannot find the part walks next door. Fast turnover is a good thing only until it becomes empty racks.

A friend once measured his cycle right after a big delivery and got a scare, because one snapshot can fool you. A single year end figure may catch a business after a big delivery or in a lull. If the trade is seasonal, a cycle measured in the wrong month will mislead. Compare the same month year over year, and watch the trend.

If you have ever compared your shop to a bigger one down the road, you know a ratio is only a mirror. Industries differ a great deal, so a grocer and a machine shop should not be judged by one another's days. Measure yourself against your own past before you look at anyone else.

Questions to answer before you leave this page

Do you know today how many days your inventory sits before it sells, and would the answer surprise you? Which customers take longest to pay, and have you ever simply asked them whether a small discount for early payment would help? What do your supplier agreements say about due dates and late charges, and is there room to ask for a few more days without hurting the relationship? If you cut your cycle by ten days, how much cash would that free, and what would you do with it? Have you pulled your last balance sheet and income statement and worked the three day counts with your own figures? And who in your life, a bookkeeper, a tax preparer, or a fellow owner, could look over your numbers with you this month?