Understanding your working capital cycle

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David Cudlip

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Understanding your working capital cycle can help you see how cash moves through your business, where money is tied up, and where there may be opportunities to improve cash flow.

Cash flow is one of the most important parts of running a healthy business, and understanding your working capital cycle can give you a much clearer view of how cash moves through the business. It helps you see how long money is tied up in stock, sales and supplier payments, and where there may be opportunities to improve efficiency.

A strong understanding of the working capital cycle can help business owners make better decisions around growth, cash flow planning and day-to-day operations.

The working capital cycle is a really useful measure of how efficiently your business manages its cash flow. It shows how long it takes your business to turn current assets, such as stock and trade debtors, into cash, and how long it takes to pay current liabilities, such as suppliers and wages.

The working capital cycle is calculated by adding the number of days it takes to sell stock, known as stock days, to the number of days it takes to receive payment from customers, known as debtor days, and then subtracting the number of days it takes to pay suppliers, known as creditor days.

For example, if your business has annual stock levels of £100,000, an annual cost of goods sold of £300,000, an average debtor balance of £50,000, annual sales revenue of £400,000, average trade creditors of £40,000, and annual purchases of £280,000, then your working capital cycle is as follows.

Stock days = (£100,000 / £300,000) x 365 = 121.67 days
Debtor days = (£50,000 / £400,000) x 365 = 45.63 days
Trade creditor days = (£40,000 / £280,000) x 365 = 52.14 days

Working capital cycle = 121.67 + 45.63 – 52.14 = 115.16 days

This means that, on average, your business takes 115.16 days to convert its stock and trade debtors into cash after paying its suppliers.

The working capital cycle matters because it affects liquidity, profitability and growth potential. A shorter working capital cycle means your business can generate cash more quickly and use it to pay off debts, invest in new projects or distribute dividends. A longer working capital cycle means more money is tied up in current assets, and this can become a barrier to growth.

To summarise, there are three main steps in the working capital cycle:

  1. Buying stock or other supplies
  2. Selling stock or services
  3. Receiving payment from customers

Positive cycle vs negative cycle

It is perfectly normal for most businesses to have a positive working capital cycle, meaning there is a period of time where they are waiting for payment before cash becomes available.

A business with a negative cycle has collected money more quickly than it needs to pay its bills, which means the final figure in the formula is negative.

For example, a negative cycle might look like this:

25 stock days + 20 debtor days – 60 creditor days = -15 days

Many businesses aim for a negative working capital cycle by moving stock more quickly, reducing customer payment terms and extending their own payment terms where possible.

Improving the working capital cycle

In reality, it is probably not feasible for many businesses to achieve a negative working capital cycle, but there are still ways to shorten and improve the cycle in any business. The shorter the cycle, the less cash is required to grow or maintain the business.

To improve it, you need to break the working capital cycle down into its three main components: stock days, debtor days and creditor days.

Improving stock days

  1. Ensure production and fulfilment are efficient so stock can be quality checked and dispatched promptly.
  2. Produce stock based on demand, which means improving the accuracy of planning and forecasting.
  3. Generate sales before stock is produced, rather than producing stock and then trying to sell it.
  4. Use pricing strategies to help move old or slow-moving stock.
  5. Optimise stock levels by using methods such as just-in-time delivery.

However, there are times when holding higher levels of stock is perfectly reasonable. For example, if you are building up stock ahead of a period of high demand.

Improving debtor days

Debtor days are a useful way of showing how efficiently a business collects money owed to it. The lower this number is, the better. When debtor days are high, it can reflect poor collection processes and may put pressure on cash levels.

  1. Improve invoice management by shortening payment terms or offering early payment discounts where appropriate.
  2. Consider invoice finance. This can allow the business to release some of the value of customer debts earlier than the agreed credit terms.
  3. Strengthen credit control by having a proactive and partly automated process that starts at customer onboarding rather than once an invoice has been raised. It is also possible to outsource credit control.
  4. Improve quality control. Invoices are often left unpaid because of disputes, and poor product or service quality can be a common cause.
  5. Consider moving fully or partly to a subscription model.

Improving creditor days

Creditor days can show how a business manages its credit arrangements with suppliers.

The initial reaction is often that higher creditor days should be the aim, as this helps retain cash for longer. However, a business that is especially slow in paying its bills may also be showing signs of difficulty in generating or retaining cash. This can lead to strained supplier relationships.

Options to improve creditor days without damaging supplier relationships include:

  1. Improve your credit rating, as stronger creditworthiness may lead to extended credit terms from suppliers.
  2. Use just-in-time methods to order stock only when it is needed.
  3. Be prepared to negotiate payment terms with suppliers. Businesses often choose suppliers based on price, product quality or speed of delivery, but payment terms can be just as important.
  4. Create or join a buying group. In some sectors, businesses can work with competitors to achieve economies of scale in purchasing. This can make you a larger customer in the eyes of suppliers and may help secure lower costs and better credit terms.

A more detailed working capital cycle

The working capital cycle used in this blog is a fairly simple view of the overall cycle. In reality, working capital requirements can vary significantly from one industry to another, and they are unlikely to remain static over time.

Some practical considerations include:

  • A working capital cycle should be recalculated regularly, and at the very least monthly.
  • Use the working capital cycle as a leading indicator of cash flow. If you improve the cycle, cash flow should improve too.
  • It is important for growing businesses to understand how working capital requirements change as the business grows. For example, a business with turnover of £50k per month, a 50% gross profit margin and a working capital cycle of 30 days requires less cash to operate than a business with turnover of £1m per month, the same 50% gross profit margin and the same 30-day working capital cycle.
  • For stock-based businesses, it is useful to break the cycle down into more detail, for example: how long raw materials sit in stock before being used in production, how long it takes to manufacture, quality check and turn items into finished goods and how long finished goods take to sell.

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Understanding your working capital cycle is not just a useful exercise for the finance team. It can give the wider business a better understanding of where cash is tied up and where improvements can be made. Even small changes to stock control, customer payment timings or supplier terms can have a meaningful impact on cash flow.

At The Advisory Group, we help businesses understand the numbers behind performance so they can plan more effectively and grow with confidence. If you would like support in reviewing your working capital cycle and what it means for your business, please get in touch here.

This publication has been prepared by The Advisory Group UK Limited and is not intended to be a comprehensive statement of law or represent specific advice. No liability is accepted for the opinions it contains. All rights reserved.

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