Working capital and the cash conversion cycle, explained with a shop

A shop can sell more every month, report a healthy profit and still struggle to pay its suppliers on Friday. The gap between profit and cash is mostly a question of timing, and the cash conversion cycle is the tool that measures it.

This guide defines the terms, gives the formulas and then works through a shop with invented numbers, so you can see each step.

Working capital in one line

Working capital is current assets minus current liabilities. Wikipedia describes it as the operating liquidity available to a business. The Corporate Finance Institute (CFI) calls it a measure of short-term liquidity: what is left once the short-term bills are paid.

Current assets are things you own that will be used up or turned into cash within a year. They include cash, inventory, money customers owe you (accounts receivable) and marketable securities.

Current liabilities are amounts you owe that fall due within a year. They include supplier invoices (accounts payable), short-term loans, and accrued expenses such as wages earned but not yet paid.

Positive working capital usually means you can meet near-term bills and fund some growth yourself. Negative working capital can point to a cash squeeze, though CFI notes that grocery stores and fast-food chains can run well with it, because they sell stock quickly and collect cash fast.

The cash conversion cycle

Working capital is a snapshot. The cash conversion cycle (CCC) shows movement: how many days cash is tied up between paying for stock and collecting money from customers. Wikipedia sums it up as the “days between disbursing cash and collecting cash”.

The formula is CCC = DIO + DSO - DPO, built from three parts.

Some sources use purchases instead of cost of goods sold for DPO, or total sales for DSO. Pick one method and keep it, so this year’s figure compares fairly with last year’s.

A shorter cycle means cash comes back faster. CFI advises comparing the figure with companies in the same industry and tracking the trend over time, rather than judging one number alone. A negative cycle is possible when customers pay you before you pay your suppliers.

Why profitable firms run out of cash

Profit is recorded when you make a sale. Cash arrives when the customer pays. Before that, you have usually paid for the stock, the rent and the wages. The longer the gap, the more cash you need to keep trading.

Growth widens the gap. Wikipedia notes that the cycle shows how long a firm is deprived of cash when it increases its investment in inventory. Double your sales with the cycle unchanged and you need roughly twice as much money sitting in stock and unpaid invoices, before any of the extra profit arrives. As Wikipedia’s working capital article puts it: “A company can be endowed with assets and profitability but may fall short of liquidity if its assets cannot be readily converted into cash.”

A worked example (illustration only)

The figures below are invented for teaching. They describe a fictional homeware shop that sells online to consumers and on credit to a few independent retailers. For simplicity, DSO uses total revenue.

First, turn the annual figures into daily ones. Cost of goods sold is £438,000 ÷ 365 = £1,200 a day. Revenue is £730,000 ÷ 365 = £2,000 a day.

• DIO = £96,000 ÷ £1,200 = 80 days
• DSO = £40,000 ÷ £2,000 = 20 days
• DPO = £36,000 ÷ £1,200 = 30 days
• CCC = 80 + 20 – 30 = 70 days

Each pound spent on stock takes about 70 days to come back as cash. The money tied up in the cycle is inventory plus receivables minus payables: £96,000 + £40,000 – £36,000 = £100,000.

Now suppose the owner makes three changes. She clears slow lines, so average inventory falls to £72,000. She asks retailers to pay in 14 days instead of 30, so average receivables fall to £30,000. And she agrees 45-day terms with her main supplier, so average payables rise to £48,000.

Sales and profit have not changed at all. The shop has £46,000 more in the bank because the same trade moves through faster.

Levers to shorten the cycle

Reduce days inventory

• Order smaller quantities more often, once you know your suppliers’ lead times.
• Review slow-moving lines every month and clear them before they tie up more cash.
• Use pre-orders or made-to-order for expensive or bulky items.
• Set reorder points from actual sales data, not habit.

Reduce days sales outstanding

• Take payment at checkout from consumers.
• Invoice trade customers on the day you deliver, with clear terms.
• Chase on the due date, not a fortnight later.
• Put a payment link on every invoice.
• If you offer an early-payment discount, check it costs less than borrowing the same money.

Increase days payables, carefully

• Ask for longer terms once you have a record of paying on time.
• Pay on the due date rather than early, unless an early-payment discount is worth taking.
• Do not stretch suppliers past agreed terms. It damages relationships, and Wikipedia’s article on the cycle warns that “a policy of strict collections and lax payments is not always sustainable.”

How to use the number

Work out your cycle each quarter from your balance sheet and profit and loss account. Watch the trend more than the level, and compare with businesses like yours: a grocer and a furniture maker will never look alike. Before any growth push, such as a large seasonal order, estimate the extra stock and receivables you will carry and arrange the cash or credit before you need it.