19.1 What Is Working Capital?

The Cash Cycle

The cash cycle, also called the cash conversion cycle, is the time period between when a business begins production and acquires resources from its suppliers (for example, acquisition of materials and other forms of inventory) and when it receives cash from its customers. This is offset by the time it takes to pay suppliers (called the payables deferral period).

Figure 19.2 Working Capital Needs Can Vary: Temporary and Permanent Working Capital

The cash cycle is measured in days, and it is best understood by examining its formula:

The inventory conversion period is also called the days of inventory. It is the time (days) it takes to convert inventory to sales and is calculated by following these steps:

1. First, calculate the Inventory Turnover Ratio using this formula:
   $$\text{Inventory Turnover Ratio} =\frac{\text{Cost of Goods Sold}}{\text{Average Inventory}}$$

   19.5

   The Average Inventory is arrived at as follows:

   $$\text{Average Inventory} = \frac{\text{(Beginning Inventory + Ending Inventory)}}{2}$$

   19.6
2. Then, use the Inventory Turnover Ratio to calculate the Inventory Conversion Period:
   $$\text{Inventory Conversion Period} = \frac{365}{\text{Inventory Turnover}}$$

   19.7

The receivables collection period, also called the days sales outstanding (DSO) or the average collection period, is the number of days it typically takes to collect cash from a credit sale. It is calculated by following these steps:

1. First, calculate the Accounts Receivable Turnover using this formula:
   $$\text{Accounts Receivable Turnover}=\frac{\text{Credit Sales}}{\text{Average Accounts Receivable}}$$

   19.8

   The Average Accounts Receivable is arrived at as follows:

   $$\text{Average Accounts Receivable} = \frac{(\text{Beginning Accounts Receivable} + \text{Ending Accounts Receivable})}{2}$$

   19.9
2. Then, use the Accounts Receivable Turnover to calculate the Receivables Collection Period:
   $$\text{Receivables Collection Period}=\frac{365}{\text{Accounts Receivable Turnover}}$$

   19.10

The payables deferral period, also known as days in payables, is the average number of days its takes for a company to pay its suppliers. It is calculated by following these steps:

1. First, calculate the Accounts Payable Turnover using this formula:
   $$\mathrm{Accounts}\mathrm{Payable}\mathrm{Turnover}=\frac{\mathrm{Cost}\mathrm{of}\mathrm{Goods}\mathrm{Sold}}{\mathrm{Average}\mathrm{Accounts}\mathrm{Payable}}$$

   19.11

   The Average Accounts Payable is arrived at as follows:

   $$\mathrm{Average} \mathrm{Accounts} \mathrm{Payable}=\frac{(\mathrm{Beginning}\mathrm{Accounts}\mathrm{Payable}+\mathrm{Ending}\mathrm{Accounts}\mathrm{Payable})}{2}$$

   19.12
2. Then, use the Accounts Payable Turnover to calculate the Payables Deferral Period:
   $$\mathrm{Payables}\mathrm{Deferral}\mathrm{Period}=\frac{365}{\mathrm{Accounts}\mathrm{Payable}\mathrm{Turnover}}$$

   19.13

Think It Through

Periods of the Cash Cycle

Scenario 1: King Sized Products (KSP) Inc. has annual credit sales of $40,000,000. The average inventory is $3,000,000, and the company has average accounts receivable of $6,000,000 and average accounts payable of $2,800,000. The cost of goods sold for KSP Inc. is $30,000,000. The cash cycle for the company is 57.2 days. Calculate the inventory conversion, receivables collection, and payable deferral periods.

Solution:

Inventory conversion period:

• $\text{Inventory Turnover Ratio} = \frac{\$\mathrm{30,000,000}}{\$\mathrm{3,000,000}}= 10 \text{times}$
• $\text{Inventory Conversion Period} = \frac{365}{10}=36.5 \text{days}$

Receivables collection period:

• $\text{Accounts Receivable Turnover} = \frac{\$\mathrm{40,000,000}}{\$\mathrm{6,000,000}}= 6.67 \text{times}$
• $\text{Receivables Collection Period}=\frac{365}{6.67}=54.7 \text{days}$

Payables deferral period:

• $\text{Accounts Payable Turnover}=\frac{\$\mathrm{30,000,000}}{\$\mathrm{2,800,000}}=10.71 \text{times}$
• $\text{Payables Deferral Period}=\frac{365}{10.71}=34 \text{days}$

$$\text{Cash Conversion Cycle} = 36.5 \mathrm{days} + 54.7 \mathrm{days} - 34 \text{days} = 57.2 \text{days}$$

19.14

The solution (the entire cash conversion cycle) is also illustrated in a chart, Figure 19.3.

Figure 19.3 Cash Conversion Cycle

Shortening the inventory conversion period and the receivables collection period or lengthening the payables deferral period shortens the cash conversion cycle. Financial managers monitor and analyze each component of the cash conversion cycle. Ideally, a company’s management should minimize the number of days it takes to convert inventory to cash while maximizing the amount of time it takes to pay suppliers.

Quickly converting inventory to sales speeds up cash inflows and shortens the cash cycle, but it also could help reduce inventory losses as a result of obsolescence. Inventory becomes obsolete because of a variety of factors including time—inventory that has not been sold for a long period of time and is not expected to be sold in the future has to be written down or written off according to accounting rules. Write-offs of inventory can result in significant losses for a company. In the food business, inventory conversion periods take on great importance because of spoilage of perishable goods; in retailing, seasonal items lose value the longer they stay on the shelves.

Various inventory management techniques are used to shorten production time in manufacturing, and in retailing, strategies are used to reduce the amount of time a product sits on the shelf or is stored in the warehouse. Production techniques such as just-in-time inventory systems and marketing and pricing strategies can have an impact on the number of days in the inventory conversion cycle.

For the receivables collection period, a relatively long receivables collection period means that the company is having trouble collecting cash from its customers and so whatever can be done to speed up collections while still offering competitive credit terms should be pursued by financial managers. For example, companies that converted paper invoicing to e-invoicing most likely reduce the average collection period by some number of days, as it makes sense that if a bill is transmitted electronically, lag time is cut (no delays because of “snail mail”) and collections (payments back to the company from customers) may happen sooner. Other credit management techniques, some of which are explained in subsequent sections, can help minimize and control the receivables collection period.

The payables deferral period is the one element that probably cannot be optimized without violating credit terms. Certainly, cash balances can be conserved by delaying payments to vendors for as long as possible; however, payments on trade credit need to be made on time or the company’s relationship with the supplier can suffer. In a worst-case scenario, the company’s credit rating could also deteriorate.

A credit rating, also called a credit score, is a measure produced by an independent agency indicating the likelihood that a company will meet its financial obligations as they come due; it is an indication of the company’s ability to pay its creditors. Three business credit rating services are Equifax Small Business, Experian Business, and Dun & Bradstreet.

Think It Through

The Cash Conversion Cycle

Considering the previous Think It Through (Scenario 1), what if you could reduce inventory levels, hold lower accounts receivable balances, and rely more heavily on accounts payable while maintaining the same sales level?

Here’s Scenario 2. Because of better inventory management, credit and collections management, and negotiation of longer payment periods with vendors, King Sized Products (KSP) Inc. needs less investment in inventory and accounts receivable and is able to utilize a greater amount of trade credit financing.

Annual credit sales are $40,000,000, average inventory is $2,800,000, average accounts receivable are $5,500,000, average accounts payable are $3,300,000, and cost of goods sold is $30,000,000. What is the cash conversion cycle?

Solution:

Inventory conversion period:

• $\text{Inventory Turnover Ratio}=\frac{\$\mathrm{30,000,000}}{\$\mathrm{2,800,000}}=10.71 \text{times}$
• $\text{Inventory Conversion Period} = \frac{365}{10.71}= 34.07 \text{days}$
• $\text{Inventory Conversion Period}=\frac{365}{10.71}=34.07 \text{days}$

Receivables collection period:

• $\text{Accounts Receivable Turnover}=\frac{\$\mathrm{40,000,000}}{\$\mathrm{5,500,000}}=7.27 \text{times}$
• $\text{Receivables Collection Period}=\frac{365}{7.27}= 50.21 \text{days}$

Payables deferral period:

• $\text{Accounts Payable Turnover} =\frac{\$\mathrm{30,000,000}}{\$3,\mathrm{300,000}}= 9.09 \text{times}$
• $\text{Payables Deferral Period}=\frac{365}{9.09}=40.15 \text{days}$

$$\text{Cash Conversion Cycle} = 34.07 \mathrm{days} + 50.21 \text{days} – 40.15 \text{days} = 44.13 \text{days}$$

19.15

Notice that the investment in inventory and accounts receivable is less and the average accounts payable is more with no change in credit sales and cost of goods sold—you would certainly anticipate a reduction in the cash conversion cycle. The improvement would be about 13 days (from 57.2 in Scenario 1 to 44.1 days in Scenario 2). Figure 19.4 shows a bar chart comparison of the two scenarios.

	Scenario 1	Scenario 2
Inventory Conversion Period	36.50	34.07
Receivables Collection Period	54.75	50.21
Payables Deferral Period	34.07	40.15
Cash Conversion Cycle	57.18	44.10

Table 19.2

Figure 19.4 Scenario 1 and 2 Comparison: Shortening the Cash Conversion Cycle

Working Capital Needs by Industry

When comparing working capital needs by industry, you can see some variation. For example, some companies in the grocery business can have very low cash conversion cycles, while construction companies can have very high cash conversion cycles. And some companies, like those in the restaurant business, can have very low numbers and even have negative cash conversion cycles.

Working capital can also differ from one industry to another. An often cited general rule is that a current ratio of 2 is considered optimal. However, general rules of thumb must be treated with caution. A better benchmarking approach is to compare a firm’s ratios—current ratio and quick ratios—to the average of the industry in which the subject company operates.

Take, for example, a home construction company. Such as firm has a long operating cycle because of the production process (building homes), and the “storage of finished goods” can result in very high current ratios—such as 11 or 12 times current liabilities—whereas a retailer like Walmart or Target would have much lower current ratios.

In recent years, Walmart Stores Inc. (NYSE: WMT) has had a current ratio of around 0.9 and has been able to manage its working capital needs by efficient management of its supply chain, quick turnover of inventory, and a very small investment in accounts receivables.¹ Big retailers like Walmart are effective at negotiating favorable payment terms with their vendors. The ability to generate consistent positive cash flow from operations allows a retailer like Walmart to operate with relatively low amounts of working capital.

The credit policies of a company also affect working capital. A company with a liberal credit policy will require a greater amount of working capital, as collection periods of accounts receivable are longer and therefore tie up more dollars in receivables.

Almost all businesses will have times when additional working capital is needed to pay bills, meet the payroll (salaries and wages), and plan for accrued expenses. The wait for the cash to flow into the company’s treasury from the collection of receivables and cash sales can be longer during tough times.

During the COVID-19 pandemic, the US government made paycheck protection program (PPP) loans available to help alleviate working capital problems for small and large business when the economy slowed because of shutdowns and social distancing. And although 60 percent of the PPP loan proceeds were to go to cover payroll-related costs, 40 percent could be used to bolster working capital to meet rent, utilities costs, and some interest expense while companies were “treading water”—waiting for positive cash flow to pick up under a recovery.²

It isn’t just during downturns that working capital is strained. Growing companies, even if they are extremely profitable, need additional working capital as they ramp up operations by acquiring raw materials, component parts, supplies, or other forms of inventory; hiring temporary or additional employees; and taking on new projects. Whenever additional resources are needed, working capital is also needed.

Some of the current assets and expenditures needed in a growing company may need to be financed from sources that are not spontaneous financing—trade credit (accounts payable). Such forms of external financing such as lines of credit, short-term bank loans, inventory-based loans (also called floor planning), and the factoring of accounts receivables might have to be relied upon.