Working capital and the cash conversion cycle, in plain terms
Working capital is the cash tied up in running a business day to day. Here is how to calculate it, how the cash conversion cycle works and practical levers small businesses can pull.
A business can be growing, profitable and still short of cash. Often the reason is working capital: money tied up in inventory and unpaid customer invoices while bills to suppliers and staff come due. Two simple measures, working capital and the cash conversion cycle, show how much cash a business needs to operate and how quickly it gets that cash back.
Working capital
Working capital is current assets minus current liabilities. Current assets are things expected to turn into cash within a year: cash itself, accounts receivable, which is money customers owe, and inventory. Current liabilities are obligations due within a year: accounts payable to suppliers, accrued wages and taxes, and the short-term portion of loans.
Positive working capital means the business has more short-term resources than short-term obligations. Negative working capital is not always a crisis. Some businesses, such as grocery chains, collect from customers immediately and pay suppliers weeks later, so they operate comfortably with negative working capital. For most small businesses, though, consistently negative working capital is a warning sign.
A related figure, the current ratio, divides current assets by current liabilities. A ratio above 1 means current assets exceed current liabilities. What counts as healthy varies widely by industry.
The cash conversion cycle
The cash conversion cycle measures how many days pass between paying cash out for inputs and collecting cash in from customers. It has three parts:
- Days inventory outstanding (DIO): how long inventory sits before it is sold. Calculated as average inventory divided by cost of goods sold, times 365.
- Days sales outstanding (DSO): how long customers take to pay. Average accounts receivable divided by revenue, times 365.
- Days payables outstanding (DPO): how long the business takes to pay its suppliers. Average accounts payable divided by cost of goods sold, times 365.
The cycle is DIO plus DSO minus DPO. Consider a hypothetical shop whose inventory sits for 60 days, whose customers pay in 30 days and which pays its suppliers in 30 days. Its cycle is 60 plus 30 minus 30, or 60 days. For two months, the shop's own cash is funding goods its customers have not paid for yet.
Why growth makes it worse
The cycle explains why fast growth can drain cash. If the shop above doubles its sales, it needs roughly twice as much cash tied up in inventory and receivables at any moment. That money has to come from somewhere, whether profits, savings, a credit line or slower payments to suppliers. A business that does not plan for this can find itself unable to pay bills during its best year. The U.S. Small Business Administration lists managing cash flow among the core skills for staying in business.
Levers to pull
Each part of the cycle suggests practical steps.
Inventory. Review which items sell slowly and reduce reorders for them. Smaller, more frequent purchases can lower average inventory, though they may cost more per unit. Clearing old stock at a discount turns dead inventory back into cash.
Receivables. Invoice promptly and clearly, with the due date stated. Offer electronic payment. Follow up as soon as an invoice is late. Some businesses offer a small discount for early payment; terms such as 2/10 net 30 mean a 2% discount if paid in 10 days, otherwise the full amount in 30. Weigh the cost: giving up 2% to get paid 20 days sooner is expensive on an annualized basis, so it makes sense mainly when cash is tight or when it cuts collection costs.
Payables. Use the full payment terms suppliers offer, paying on the due date rather than early, unless there is a discount worth taking. Negotiating longer terms with key suppliers can shorten the cycle without any change to operations. Paying late, however, damages relationships and can bring fees.
Deposits and prepayment. Businesses doing custom or project work can often ask for a deposit up front, which turns the cycle in their favor.
Financing working capital
When the cycle cannot be shortened enough, businesses finance the gap. A revolving line of credit from a bank lets a business borrow as needed and repay when customers pay. SBA programs, including the 7(a) program and CAPLines, can support working capital needs through participating lenders. Invoice financing and factoring advance cash against receivables, usually at a higher cost. Merchant cash advances can be very expensive, and the Federal Trade Commission has brought cases against some providers over deceptive practices, so the terms deserve careful reading.
Track it monthly
Most accounting software can produce the balance sheet figures needed for these calculations. Tracking the cycle month by month shows whether the business is getting more or less efficient at turning work into cash. A rising DSO, for example, is an early warning that customers are paying more slowly, often before the bank balance shows it.
The bottom line
Profit tells you whether a business makes money. Working capital and the cash conversion cycle tell you whether it will have the money when it needs it. Shortening the cycle by even a couple of weeks can free up a meaningful amount of cash without a single extra sale.
This article is general information, not financial or accounting advice. The example figures are illustrative.