Maintaining healthy cash flow is challenging for many businesses. Having a better understanding of the working capital cycle and how it affects your cash flow can help. Here’s what you need to know about working capital and how the cycle works.
So, what is a working capital cycle? A working capital cycle is the amount of time it takes to get a return on the investment you made. Simply put, it’s the amount of time it takes to go from sale to cash in the bank for what you’ve sold.
The cycle looks a little different depending on whether you sell goods or services.
Retailers sell goods to customers or other businesses. They purchase stock, and customers purchase their products either in-person or online. For retailers, the cycle of working capital looks a little something like this:
- First, you purchase inventory. Then, depending on your agreement with the supplier, you may have to pay immediately or according to the agreed-upon payment terms (net 30, net 60, etc.).
- You receive your inventory.
- You sell your stock, and receive payment.
- Payments may be immediate, or based on agreed-upon payment terms.
- It takes time to sell your inventory, which drags out the working capital cycle.
The working capital cycle gives you an indication of how much capital you have in your business to cover your expenses while waiting for customer payments and your inventory to sell out.
Service providers sell services to clients or other businesses. They agree to perform a service, and the customer pays upon delivery or through an agreed-upon milestone payment cycle. For service providers, the cycle looks a little bit different, but the challenges are the same.
- You come to an agreement to sell services to a customer.
- You deliver those services, and invoice the customer. Invoicing may happen at the point of the agreement (before the work starts) or at delivery.
- Invoicing customers increases your accounts receivables, but that cash is still not in your bank account.
- The customer makes a payment, and the cycle starts again.
For service businesses, the cycle is the time between having to pay staff/overhead to complete the work until the customer pays the invoice.
Whether you run a retail or service-based business, your goal is to reduce your cycle as much as possible. The shorter your cycle, the quicker you get paid and the less cash flow issues you will run into.
In order to do that, you first have to use the working capital cycle formula to determine how long your cycle is. Once you know its length, you can determine how much you want to reduce it and how to get started.
Use this formula to calculate your cycle:
- Inventory Days (how long it takes to sell out your inventory) + Receivable Days (how long it takes to receive payment) – Payable Days (how long until you have to pay your supplier) = Your Working Capital Cycle
Now that you understand the length of your cycle, you can take steps to reduce it. Here are some tips:
- Be smart about purchasing inventory. Don’t buy too much stock at once, and only focus on items that are in high demand.
- Deliver more quickly. For service-based businesses, quick deliveries mean quick payments and shorter cycles. It’s important to find ways to streamline the process without compromising quality.
- Encourage customers to pay quickly. Give your customers an incentive to pay invoices early, and make an effort to keep on top of customers who are late with their payments.
- Delay bill payments. Make your payments on time but delay them as long as possible to keep more cash in the bank.
It’s also a great idea to use cash flow management tools to help you keep on top of your cash flow and be proactive about avoiding potential cash flow shortages.
As a business owner, it’s important to understand working capital and the cycles that go with it. Reducing your cycle as much as possible will help your business maintain positive cash flow. Use the tips above to keep your cycle short while still meeting your obligations and customers’ expectations.