How do you manage working capital? The receivables, inventory and payables cycle
Working capital is where profit waits before it becomes cash. A few days’ change in receivable, inventory or payable periods can create a serious cash need in a growing company.
Working capital is the money a company ties up to keep its day-to-day operations running. For management purposes the most useful definition is net working capital: trade receivables plus inventory, minus trade payables. It shows the amount the company has to fund, from its own resources or with borrowing, while waiting for sales to turn into cash.
The cash conversion cycle
Reading working capital in days makes it easier to manage:
| Indicator | Simple calculation | Meaning |
|---|---|---|
| Days sales outstanding (DSO) | Trade receivables / sales × 365 | How many days from sale to collection? |
| Days inventory outstanding (DIO) | Inventory / cost of sales × 365 | How many days do goods sit in stock? |
| Days payables outstanding (DPO) | Trade payables / cost of sales × 365 | How many days until suppliers are paid? |
| Cash conversion cycle | DSO + DIO − DPO | How many days is money tied up in operations? |
A company with a 90-day cash conversion cycle permanently funds roughly three months of cost of sales.
A hypothetical example
Take a company with annual sales of TRY 120 million. If its collection period stretches from 60 to 75 days, average receivables rise from about TRY 19.7 million to TRY 24.7 million (120 × 60/365 and 120 × 75/365). A delay of just fifteen days creates an additional cash need of roughly TRY 5 million, while nothing changes on the income statement.
The example also explains why the gap between profit and cash is wider in growing companies. I go into it in Why do profitable companies run out of cash?
Managing receivables
- Track by customer. An average collection period can hide the delays of a few large customers.
- Separate terms from actual payment behaviour. Planning should follow what customers actually do.
- Discuss terms together with price. Especially when inflation is high, if the financing cost of credit sales is not reflected in pricing, the margin quietly erodes.
Managing inventory
Inventory is goods that have been paid for but not yet sold. Identifying slow-moving items, ageing the inventory and linking purchasing decisions to the sales forecast often deliver the fastest improvement in working capital.
Managing payables
Extending supplier terms eases cash, but only up to a point. Systematically delaying payments damages supplier relationships and prices. The goal is to align the payment calendar with the collection calendar.
Working capital and planning
Working capital assumptions are the common foundation of the budget, the cash plan and the business plan. When sales growth is planned, the growth in receivables and inventory must be planned too; otherwise the growth plan ends in a cash shortfall. I cover this link on the cash flow management page and in the 13-week cash flow article.
Frequently asked questions
Is a negative cash conversion cycle good?
It means the company pays its suppliers after it has collected from customers, which is an advantage for cash. It is common in sectors such as retail that sell for cash. But the advantage depends on supplier terms and can reverse quickly if sales shrink.
How is a working capital need financed?
Equity, short-term loans, factoring and supplier terms are the main sources. Which fits depends on whether the need is permanent or seasonal: rolling a permanent need over with short-term loans creates a maturity mismatch.