Lesson 5.1 40 min
Working capital and the cash conversion cycle
How inventory, receivables and payables tie up cash, how to measure the days, and why growth consumes cash before it makes any.
Working capital is the money a business has tied up in the short-term machinery of trading: stock on the shelf, invoices customers have not yet paid, less what is owed to suppliers. A business can be profitable and still run out of cash because this machinery has to be funded before sales turn into cash.
The three balances
Trade working capital is made of three items, all taken from the balance sheet in lesson 1.2.
Trade working capital = Inventory + Receivables − Payables
Inventory and receivables tie up cash. Payables release it, because suppliers are in effect lending the business money until their invoice is due. Other current items, such as cash itself and tax owed, are left out so that the measure shows the trading cycle.
Measuring in days
A balance in dollars is hard to judge. The same balance can be healthy for one business and dangerous for another. Converting it to days of activity makes it comparable.
- Days inventory outstanding (DIO) = Inventory ÷ cost of goods sold per day.
- Days sales outstanding (DSO) = Receivables ÷ revenue per day.
- Days payables outstanding (DPO) = Payables ÷ cost of goods sold per day.
Each uses the year-end balance and a 365-day year in the case below. Using the average of the opening and closing balances is better when the balance moves a lot during the year, and the year-end figure is a simplification. Payables are measured against cost of goods sold because suppliers are paid for what the business buys, not for what it sells.
The cash conversion cycle, or CCC, joins them.
Cash conversion cycle = DIO + DSO − DPO
It is the number of days between paying suppliers and collecting from customers. A cycle of 70 days means the business funds 70 days of its costs itself. A negative cycle, which supermarkets achieve by selling stock before they pay for it, means suppliers fund the business.
Why growth consumes cash
Inventory, receivables and payables move with sales. If sales grow 25% and the days stay the same, each balance grows 25%. The net cash tied up grows by the same proportion. The business pays for more stock and waits for more customers before it receives the extra profit. This is why a business that is growing fast can be short of cash even though profit is rising, a pattern called overtrading.
Lesson 4.2 mentioned working capital as an item in an investment appraisal. This is where it comes from: a project that adds sales adds receivables and inventory, and the funding of them belongs in the cash flows.
Worked case
Alder Print Works
Alder Print Works is a fictional print shop. For the year it has revenue of $876,000 and cost of goods sold of $584,000, a gross profit of $292,000 or 33.3%. At year-end it holds inventory of $64,000, receivables of $144,000 and payables of $48,000. Revenue per day is $2,400 and cost of goods sold per day is $1,600.
| Balance $ | Per day $ | Days | |
|---|---|---|---|
| Inventory, on cost of goods sold | 64,000 | 1,600 | 40 |
| Receivables, on revenue | 144,000 | 2,400 | 60 |
| Payables, on cost of goods sold | 48,000 | 1,600 | 30 |
| Cash conversion cycle, days | 70 |
Alder takes 70 days from paying for paper and ink to collecting from the customer who buys the print. Its trade working capital is $64,000 + $144,000 − $48,000 = $160,000. If the business borrows that amount on a credit line at 9%, the cost is $14,400.00 a year.
What shortening the cycle frees
| Change | Days | Cash freed $ |
|---|---|---|
| Collect 10 days sooner | 10 | 24,000 |
| Hold 10 days less stock | 10 | 16,000 |
| Pay suppliers 15 days later | 15 | 24,000 |
| All three | 64,000 |
Each day is worth a different amount: a day of receivables is worth $2,400, because it is measured on revenue, and a day of payables or inventory is worth $1,600, because those are measured on cost. Taken together the three changes cut the cycle from 70 to 35 days and free $64,000. At 9% that is worth $5,760.00 a year in interest.
What growth does
If Alder grows sales 25% and the days stay the same, each balance rises 25%.
| Now $ | At +25% $ | Change $ | |
|---|---|---|---|
| Revenue | 876,000 | 1,095,000 | 219,000 |
| Gross profit | 292,000 | 365,000 | 73,000 |
| Inventory | 64,000 | 80,000 | 16,000 |
| Receivables | 144,000 | 180,000 | 36,000 |
| Payables | (48,000) | (60,000) | (12,000) |
| Cash tied up in trade working capital | 160,000 | 200,000 | 40,000 |
The extra gross profit is $73,000 before overheads, but the business first needs $40,000 more to carry stock and customers, net of what suppliers lend it. That is the working capital that growth uses. The funding comes from cash on hand, from the credit line, or from shortening the cycle.
Template
Cash conversion cycle workbook
Enter revenue, cost of goods sold and the three balances. The sheet calculates DIO, DSO, DPO and the cycle, shows the cash freed by changing each days figure, and prices the funding at a credit line rate. A growth sheet shows how much extra working capital a given sales increase needs. Alder Print Works is loaded.
The full working file, 5-1-cash-conversion-cycle.xlsx, is in the Accounting and Finance Toolkit, Complete Track 1. The lesson above teaches the method and shows the worked numbers, so you can build it yourself in any spreadsheet.
Exercises
Work these, then open the answers
Alder gets customers to pay in 45 days instead of 60. What is the new cycle, and how much cash does it free?
Answer
The cycle becomes 40 + 45 − 30 = 55 days. Receivables fall by 15 days × $2,400 = $36,000.
Alder agrees longer terms with its paper supplier, from 30 days to 40. How much cash does that release?
Answer
10 days × $1,600 of cost per day = $16,000.
Explain why DPO is measured against cost of goods sold and not revenue.
Answer
Payables arise from what the business buys, so the daily purchase cost is the matching measure. Revenue includes the gross profit, which no supplier is owed.
Check
5 questions
Sources
Sources
- Principles of Accounting, Volume 1: Financial Accounting, OpenStax, Rice University
- Principles of Finance, OpenStax, Rice University