How to Calculate Working Capital and Cash Conversion Cycle

Use these, with annual figures unless you're working from a shorter period:

• Net working capital: current assets minus current liabilities.
• Operating working capital: accounts receivable plus inventory minus accounts payable, which leaves out cash and debt so you can see the operating effect.
• Days sales outstanding (DSO): accounts receivable divided by revenue, times 365.
• Days inventory outstanding (DIO): inventory divided by cost of goods sold, times 365.
• Days payables outstanding (DPO): accounts payable divided by cost of goods sold, times 365.
• Cash conversion cycle (CCC): DSO plus DIO minus DPO.

Use average balances over the period for the most accurate result, especially if your business is seasonal. If you sell services and hold no inventory, DIO is zero and the cycle is DSO minus DPO.

Say a small distributor has annual revenue of $2,400,000 and cost of goods sold of $1,500,000. Say at year-end it holds $300,000 in receivables, $250,000 in inventory and $150,000 in payables.

Say DSO works out to 300,000 divided by 2,400,000, times 365, or about 45.6 days. DIO is 250,000 divided by 1,500,000 times 365, about 60.8 days. DPO is 150,000 divided by 1,500,000 times 365, about 36.5 days. The cash conversion cycle is 45.6 plus 60.8 minus 36.5, or about 69.9 days.

In this example, operating working capital is $300,000 plus $250,000 minus $150,000, which is $400,000. That's the cash the business has tied up in operations. Now suppose you collect ten days faster: at $2,400,000 of revenue, each day of sales is about $6,575, so ten days frees roughly $65,800. That's real cash without new borrowing.

A growing business needs more receivables and inventory before the extra cash arrives. If you keep the same cycle, the working capital you need scales roughly with revenue.

For example, say the distributor above plans to grow revenue by 25 percent. Holding days constant, say operating working capital rises from $400,000 to about $500,000, so the business needs an extra $100,000 to fund growth even if it's profitable. If profit and existing cash can't cover it, you need a line of credit, tighter terms or slower growth. Many profitable small companies run into cash trouble this way.

Use this to plan: forecast revenue, apply your days assumptions, and see how much cash you'll need each quarter. Then compare the result to your runway calculation so you know when to arrange financing, before you need it.

Each lever has a cost, so choose based on your customers and suppliers:

1. Speed up collections. Invoice promptly, shorten terms, follow up before the due date and consider deposits or milestone billing. The risk is friction with customers who expect longer terms.
2. Reduce inventory. Cut slow-moving items, order more often in smaller batches and tighten forecasts. The risk is stockouts and lost sales.
3. Extend payables. Negotiate longer terms with suppliers and pay on the due date, not early. The risk is damaging supplier relationships or losing early-pay discounts, so weigh those against the cash benefit.
4. Use financing for the gap. A line of credit can bridge a cycle that can't be shortened, at an interest cost.

See optimizing working capital through DSO, DPO and DIO for tactics and the cash conversion cycle for distributors for an example in that industry.

There's no single good number, because it depends on your industry, model and terms. Better questions are these:

• Is the cycle getting shorter or longer over the last four to eight quarters?
• Does a growth plan fit within available cash and credit?
• Are receivables aging past terms, or inventory sitting for months?
• Can you pay obligations on time without stretching suppliers?

Watch out for a high current ratio that includes stale receivables or obsolete inventory, since it makes the balance sheet look healthier than the cash is. Track the metrics monthly using consistent definitions, and see your accounts payable process for the payable side. A business banking account that separates operating cash, taxes and debt payments can make it easier to see what's available. Mercury and Relay are both options; confirm in a demo how each handles sub-accounts and integration with your accounting software.