Understanding Your Working Capital Cycle!!

If CASH is king, then CASH FLOW is queen! 

There is literally nothing that is more critical to the success of your business than cash flow. Understanding the components of and influences on cash flow is both intuitive and mysterious.

First, a quick review pf the cash flow cycle (aka the Working Capital Cycle).

Let’s walk through a quick example of this cycle for a single transaction. Put yourself in the shoes of Sam, the owner of Specialized Shipping Containers – makers of custom shipping containers.

• When a customer places a purchase order, Sam (you) sends a request for the raw material (inventory) from your supplier. The inventory is delivered the same day and you are given N30 (net 30) days to pay.
• It takes 15 days to build the custom container; 1 day to deliver it and the customer is immediately invoiced.
• Once the customer is invoiced, you allow them N30 days to pay in full.

Here is one way to look at the transaction:

Here is the same transaction shown as the Working Capital Cycle.

The Working Capital Cycle breaks the transaction into 4 components: the holding period (when you possess the raw materials, work in progress and finished goods); the payment period (the N30 terms from the suppliers); the collection period (the N30 terms for your customer) and the Working Capital Need.

The Working Capital Need is the gap between the time when cash flows out of your account (to pay your supplier) and into your account (from your customer). This gap must be filled with either cash or borrowed funds (ie. a line of credit).

Stated another way: Working Capital Need = Holding Period + Collection Period – Payment Period

This example is basic, the Working Capital Cycle gets complex quickly when you add multiple purchase orders and different inventory suppliers (all with different payment terms). Not to mention the impacts of labor and other costs.

Layering the unique cash flow cycle, and the potential Working Capital Need, for each of the orders would be a monumental and agonizing task. Fortunately, there is a way to analyze your Working Capital Cycle; and calculate the Working Capital Need. This can be accomplished in three simple steps.

1. Calculate the Working Capital Need using the formula given above.
2. Calculate the daily average Cost of Goods Sold by dividing Cost of Goods Sold by 365.
3. Multiply the Working Capital Need by the daily Cost of Goods Sold

The components of the Working Capital Need can be calculated simply by following the process below:

Holding Period is also called Inventory Days on Hand (IN DOH). It defines the number of days it takes to turn your inventory (transform it into cash). The lower the number, the faster you convert inventory to cash – the less cash you have tied up in inventory. The cost of inventory is captured in your “Cost of Goods Sold” therefore to calculate IN DOH:

(Ending Inventory / Cost of Goods Sold) x 365

Collection Period can be referred to as Accounts Receivable Days on Hand (AR DOH). It is a representation on how long your Accounts Receivables is outstanding. The lower the number, the faster your clients pay (the less you are their “bank”), the less cash you have tied up in accounts receivable. In the circle of life, you convert Sales into Accounts Receivable, so AR DOH is calculated by:

(Ending Accounts Receivable / Total Sales) x 365

That means that the Payment Period is Accounts Payable Days on Hand (AP DOH); or how long you can hold on to your cash by using the terms your suppliers give you. The higher the number, the longer you can hold on to your cash. You get terms from your suppliers as you order materials and just like IN DOH – the cost of this is captured in your Cost of Goods Sold. To calculate AP DOH:

(Ending Accounts Payable / Cost of Goods Sold) x 36

We can now calculate the Working Capital Need:

To do so, we need some financial information from Specialized Shipping Containers (below).

Step 1: Calculate the Working Capital Need using the formulas given above.

Holding Period (IN DOH) =             ($150,000 / $2,740,000) x 365 = 19.98

Collection Period (AR DOH) =        ($175,000 / $3,765,000) x 365 = 16.97

Payment Period (AP DOH) =    ($75,000/ $2,740,000) x 365 = 9.99

 Working Capital Need = Holding Period + Collection Period – Payment Period

Working Capital Need =    19.98 + 16.97 – 9.99

Working Capital Need = 26.96

Step 2: Calculate the daily average Cost of Goods Sold by dividing Cost of Goods Sold by 365.

($2,740,000 / 365) = $7,506.85

Step 3: Multiply the Working Capital Need by the daily Cost of Goods Sold

26.96 x $7,506.85 = $202,357

As there is $55,000 of cash on hand – the owners of Specialized Shipping Containers will need to have $147,000 available on a line of credit (or personal cash) or they will need to manage their vendors and customers terms better to improve their Working Capital Cycle.

The moral of the story is – the lifeblood of your business is cash flow. Knowing how the terms that you negotiate with customers and suppliers is also known as the Working Capital Cycle and is critical to you achieving the strategic goals of your company.

Leave a comment and let me know if this explanation was meaningful to you. I would be honored if you share this article with your network to allow them to better understand their business’ Working Capital Cycle.

Greg Martin is an entrepreneur’s insider to the banking industry and passionately believes that every person was uniquely designed for a higher purpose and calling. Greg guides entrepreneurs in defining and achieving their purpose and calling. His deepest passion is living life with his wife of 17 years and their wonderful son.