Working capital 101


What is working capital?

The basics here are simple: working capital is a view into the financial liquidity of your company’s balance sheet, whether you are a large corporation or a small business. Calculating the amount of working capital isn’t difficult, however, trying to increase it can be a heavy lift for multiple departments throughout the organization, including Procurement, Sales, Accounts Payable, and Accounts Receivable.

Strictly speaking, your Net Working Capital (NWC) is your company’s current assets minus current liabilities. Positive working capital helps ensure smooth business operations and achieve growth-related Target Business Outcomes; the more working capital you have, the easier it becomes. Negative working capital, on the other hand, becomes a hindrance to growth and therefore makes it difficult to implement key Target Business Outcomes.


Calculating your cash conversion cycle

Your cash conversion cycle (CCC) measures how long working capital (cash) is tied up from the point when your company pays for expenditures to when that purchase becomes a final product and is sold.

As an example, suppose you are the owner of a company that stocks and sells lunchboxes. You get lunchboxes from a supplier, you stock them, and then sell them to your customers. To calculate your working capital cycle, you need to understand your cash conversion cycle, which is made up of three metrics:


    • The number of days of inventory you have (Days Inventory Outstanding or DIO)
    • The number of days it takes you to get paid once you sell something (Days Sales Outstanding or DSO)
    • The number of days it takes you to pay your suppliers (Days Payable Outstanding or DPO)


The three metrics are calculated in similar ways:

Let’s look at your lunchbox company that has $2 million in sales and $1 million in COGS, and see how it looks in the three separate areas at this current time:


    • The company has $100,000 in inventory. $100k / $1 million * 365 = 36.5-day DIO
    • The company has $400,000 in receivables. $400k / $2 million * 365 = 73-day DSO
    • The company has $50,000 in payables. $50k / $1 million * 365 = 18.25-day DPO


Once you know these three numbers, the CCC can now be arrived at using the following formula:
DIO + DSO – DPO = cash conversion cycle

Using the CCC calculation above, we would plug in the following:
36.5 DIO + 73 DSO – 18.25 DPO. This equals a 91.25-day CCC for your lunchbox company.

In this example, it takes your business approximately three months to convert your assets into money in the bank, ensuring you have enough cash. Knowing whether that number is good or not varies by industry. Some industries have CCCs that are multiple times that of other industries, so it’s difficult to take a hard line and say, “X days is the ideal CCC.” Additionally, there is a discussion of yield; you might be fine with a lower DPO (for example) if it means you will earn above a certain discount when you pay a supplier early to reduce operating expenses.


Focus on working capital management

If your company’s working capital needs are not being met and you would like to increase liquid assets (i.e., your cash and cash equivalents) you might consider reducing your CCC. On the surface, it looks simple:


    1. Work on negotiating better payment terms with your suppliers, thus increasing your DPO
    2. Get paid faster by your customers, thus reducing your DSO
    3. Move your products faster or hold less inventory, thereby reducing your DIO


However, these things are easier said than done. DPO is often considered the easiest way to increase working capital, but that can be difficult if not executed properly. Simply paying suppliers late may free up some short-term working capital, but the long-term ramifications will likely outweigh any immediate benefits. Often, companies may call a supplier and ask if they will “pretty please” extend the payment terms or renegotiate credit terms, but the results will likely be disappointing. A successful extension across suppliers will require having the benchmarks for the various companies/industries you are working with, ensuring you are going after the correct suppliers, and that there is enough evidence indicating you are getting a poor term, in the hopes that it forces their hand.

DSO works in a similar way to shorten it. Suppliers will often work with customers at contract renewal time (or new pros as when going through redlines) in order to get payment terms shortened. But salespeople will often lack the ammunition needed to enforce the terms. A prospect that says “no” to Net 30 terms needs to have a logical reason for that specific term. Without that justification, a salesperson, who is focused on making the sale, might decline to push back. Giving your sales team the ammunition needed to justify shorter payment terms and potentially tying a small part of their compensation directly to the payment term can result in greater success with clients.

Both longer DPO and shorter DSO can be achieved with Supply Chain Financing (SCF), but while many SCF vendors pitch that option as a one-size-fits-all solution, SCF should only be used where appropriate. If not structured correctly, lenders can see it as increasing short-term debt and therefore financial obligations.

DIO is the trickiest one. To ensure it is low requires a careful balance across the manufacturing and operations teams. There is no easy solution here, but rather a multitude of levers that all must be carefully evaluated. What looks like a simple way to reduce DIO by a couple of days could have disastrous ripple effects across the company if it results in a shortage of key components, raw materials, and/or ready-to-ship products.

It’s not always easy to increase NWC, and there are many mistakes that can be made along the way. In order to mitigate any problems, you should be partnering with a company that understands how to identify the suppliers/customers who can bring in the strongest results. They will then develop a strategy for each supplier/customer, including how to best get buy-in from them.

Working capital is not too difficult to understand but trying to increase it can be a futile endeavor if you do not have the right resources at your side to ensure the highest success rate. Improving your cash flow statement without increasing short-term liabilities or long-term debt is a tricky path to navigate.