What It Measures
The working capital cycle measures the amount of time that elapses between the moment when your business begins investing money in a product or service, and the moment the business receives payment for that product or service. This doesn’t necessarily begin when you manufacture a product—businesses often invest money in products when they hire people to produce goods, or when they buy raw materials.
Why It Is Important
A good working capital cycle balances incoming and outgoing payments to maximize working capital. Simply put, you need to know you can afford to research, produce, and sell your product.
A short working capital cycle suggests a business has good cash flow. For example, a company that pays contractors in 7 days but takes 30 days to collect payments has 23 days of working capital to fund—also known as having a working capital cycle of 23 days. Amazon.com, in contrast, collects money before it pays for goods. This means the company has a negative working capital cycle and has more capital available to fund growth. For a business to grow, it needs access to cash—and being able to free up cash from the working capital cycle is cheaper than other sources of finance, such as loans.
How It Works in Practice
The key to understanding a company’s working capital cycle is to know where payments are collected and made, and to identify areas where the cycle is stretched—and can potentially be reduced.
The working capital cycle is a diagram rather than a mathematical calculation. The cycle shows all the cash coming in to the business, what it is used for, and how it leaves the business (i.e., what it is spent on).
A simple working capital cycle diagram is shown in Figure 1. The arrows in the diagram show the movement of assets through the business—including cash, but also other assets such as raw materials and finished goods. Each item represents a reservoir of assets—for example, cash into the business is converted into labor. The working capital cycle will break down if there is not a supply of assets moving continually through the cycle (known as a liquidity crisis).
The working capital diagram should be customized to show the way capital moves around your business. More complex diagrams might include incoming assets such as cash payments, interest payments, loans, and equity. Items that commonly absorb cash would be labor, inventory, and suppliers.
The key thing to model is the time lag between each item on the diagram. For some businesses, there may be a very long delay between making the product and receiving cash from sales. Others may need to purchase raw materials a long time before the product can be manufactured. Once you have this information, it is possible to calculate your total working capital cycle, and potentially identify where time lags within the cycle can be reduced or eliminated.
Tricks of the Trade
For investors, the working capital cycle is most relevant when analyzing capital-intensive businesses where cash flow is used to buy inventory. Typically, the working capital cycle of retailers, consumer goods, and consumer goods manufacturers is critical to their success.
The working capital cycle should be considered alongside the cash conversion cycle—a measure of working capital efficiency that gives clues about the average number of days that working capital is invested in the operating cycle.