On this page
- What is working capital?
- How to measure your cash conversion cycle
What is working capital?
Working capital in business is made up of these core components:
- stock management.
- payment of suppliers (creditor payments).
- collection of cash from customers (debtor collection).
Often referred to as 'the working capital cycle', this is really about the length of time it takes from using your cash to purchase stock (or perhaps getting it from a supplier on credit terms), and using the stock, possibly for a manufacturing purpose (hence creating part of the cycle called 'work in progress'), to securing the sale and receiving the cash.
The working capital cycle
Between each stage of the working capital cycle, there is a time delay. For some businesses, there could be a substantial length of time to make and sell the product. For these, a large amount of cash – also referred to as working capital will be required to survive. Others may receive their cash very quickly after paying out for stock, even before they have paid their bills. Service businesses will not need to pay out cash for stock and, therefore, will need less working capital.
How to measure your cash conversion cycle
The cash conversion cycle measures the overall number of days to convert your trade from the cash outflow at the beginning of the working capital cycle to cash received at the end of the cycle.
e.g. The time taken to move from the start to the finish of the working capital cycle is called the cash conversion cycle. This measures the overall number of days to convert your trade from the cash outflow at the beginning of the working capital cycle to cash received at the end of the cycle.
The above diagram shows: before you can sell anything, you have to buy something i.e. stock or labour.
Your sales cycle determines how long the stock sits in store, for example, you may hold on to stock for 60 days.
Suppliers terms reduce the cash conversion cycle. The longer you have to pay the supplier the shorter your cash conversion cycle will be.