Working capital: the days between paying out and being paid

CB1 · Business Finance · 9 min read

What working capital is for

A trading business cannot buy and sell at the same instant. It buys goods, holds them, sells them, and waits to be paid. Through all of that the money has left and not come back, and something has to cover the gap.

That something is working capital: inventory plus receivables less payables. It is not an asset the business wants. It is the cost of the delay, and the whole management of it is the business of making the delay shorter.

The cycle, measured in days

Three measurements, each a stock divided by the flow that passes through it, multiplied by the days in the year.

Each one answers a plain question: how long do goods sit before they sell, how long do customers take to pay, how long do we take to pay our suppliers. Put them together and

The first two are time during which the business has paid and not been paid. The third is time during which someone else is funding it, so it comes off. What is left is the number of days the business funds its own trading, and it is the single most useful number about the short-term finances of a trading company.

Notice the denominators. Inventory and payables are measured against cost, because that is what they are recorded at, and receivables against revenue, because that is what a customer owes. Using revenue throughout is the most common error in this calculation, and it quietly understates inventory days by the whole gross margin.

The mechanism: a cycle is a funding requirement, and growth multiplies it

Here is the part worth carrying away. Hold the three day-counts constant and let sales grow. Every leg of the working capital grows in the same proportion, because each is a number of days of a flow that has grown.

So working capital scales with revenue, and the increase has to be funded in the year it happens. A business growing at 50% with a 65-day cycle needs half as much again tied up in trading, found from profit, from borrowing, or from the shareholders.

This is the same arithmetic as the profit-and-cash page, seen from the balance sheet instead of the cash flow statement, and it produces the same uncomfortable conclusion: the faster a profitable business grows, the more cash it swallows. Growth is funded, not earned.

Two consequences follow.

Shortening the cycle releases cash once, and permanently. Cut receivable days by fifteen and the business gets fifteen days of revenue back, as a one-off receipt, and never needs it again. It is the cheapest funding a company has, because it is not funding at all.

Lengthening it is a loan from your suppliers, and not a free one. Taking an extra month to pay improves the cycle on paper. It also forfeits settlement discounts, erodes the relationship, and ends with the supplier either pricing it in or refusing credit. A rising payable-days figure is as often a symptom of distress as a sign of good management, and telling the two apart means looking at whether anything else in the accounts is deteriorating.

The three legs, and what actually moves each one

Inventory

Held because demand and supply do not arrive on schedule. Less of it means less cash tied up and more risk of being unable to sell. The balance is a commercial judgement and not an accounting one, and a company that has driven inventory days very low has bought cash with the risk of a stock-out.

Receivables

Credit is a selling term. Offering it wins business and costs funding, and it carries a second cost that students forget: some of it is never collected. Tightening credit releases cash and loses the customers who needed the credit, which is why the decision belongs with the people who know the margin on those customers.

Payables

The only leg that helps, and the one with a trap in it. A settlement discount for early payment is an interest rate in disguise, and often a very high one. Giving up 2% to hold money twenty days longer is paying 2% for twenty days — a rate worth computing before congratulating yourself on the extra days.

Where marks are lost

Using revenue as the denominator for inventory or payables. The error above, and it is worth a deliberate check.

Mixing a year-end stock with a full-year flow for a seasonal business. A toy retailer's December inventory and its February inventory describe different companies. Use an average where the question gives you one.

Treating a short cycle as unambiguously good. It can mean tight management. It can also mean a business that has run out of stock, is refusing credit to good customers, or is being pushed onto cash terms by its suppliers.

Confusing the cycle with liquidity. The cycle is about speed; the current ratio is about whether there is enough to pay what is due. A company can have an excellent cycle and still miss a payment next week.

Questions students ask

Can the cycle be negative?

Yes, and it is a formidable position. A business that is paid before it pays — a supermarket selling for cash while taking sixty days from its suppliers, a subscription business billing in advance — is funded by its own trading, and grows faster without needing money. It is the mirror image of the recruitment agency on the profit-and-cash page, and it is worth recognising as the same arithmetic with the sign reversed.

Which leg should a company attack first?

The one with the most days in it, weighted by the money each day represents — and those are not always the same leg, because receivable days are measured against revenue and the other two against cost. The worked example shows a case where the longest leg in days is not the largest in rupees.

Why 365 and not 360?

Either is acceptable as long as it is stated and used consistently, and 360 makes the arithmetic cleaner. The choice changes every day-count by about one and a half per cent, which never changes a conclusion but does change a figure — so write down which one you used.

A worked example

An invented example, built for this page. A building-materials dealer in Coimbatore. Every figure is made up and chosen so that the arithmetic is exact, and a 360-day year is used throughout and stated here so no step is ambiguous.

Two daily rates follow, and both are exact, which is why these figures were chosen:

The three legs

The dealer pays for cement, holds it 50 days, sells it, waits 60 days to be paid, and has had 45 of those days funded by its own suppliers. Sixty-five days of trading are funded by the dealer.

Check every leg a second way

Rebuild each balance from its own day-count and its own daily rate, using the printed figures. Inventory and payables are at cost, receivables at selling price.

Three for three, so the day-counts are right and the ₹320 lakh is the money the 65 days actually tie up.

The trap: 65 days cannot be turned into rupees with one rate

It is tempting to write "65 days at ₹5 lakh a day, so ₹325 lakh". Check it against the ₹320 lakh just computed and it is wrong, and the reason is instructive.

Divide the real figure by each daily rate: 320 ÷ 5 = 64 days of revenue, and 320 ÷ 4 = 80 days of cost of sales. Neither is 65. The cycle's three legs are measured against two different bases — receivables at selling price, inventory and payables at cost — so the total in days is not convertible to money by any single rate. The cycle is a measure of speed; the ₹320 lakh is the measure of money, and you get it by adding the three balances, never by multiplying the cycle.

What growth costs

Revenue rises 50% to ₹2,700 lakh with the same margin and the same three day-counts, so cost of sales becomes 1,440 × 1.5 = ₹2,160 lakh, and the daily rates become ₹7.50 lakh and ₹6 lakh.

The dealer must find 480 − 320 = ₹160 lakh to support the extra trading, before a rupee of it has been collected.

Check that a second way. If the day-counts do not change, working capital is proportional to revenue, so it should simply scale: 320 × 1.5 = ₹480 lakh, an increase of 320 × 0.5 = ₹160 lakh. The leg-by-leg table and the scaling argument agree exactly, which they must.

Now put that beside the profit. At an operating margin of 5% the dealer earns 5% × 2,700 = ₹135 lakh in the growth year, against the ₹160 lakh the growth demands. A profitable year, and ₹25 lakh short.

Where the cash actually is, and the cheapest place to find it

Receivables are the largest leg in rupees — ₹450 lakh of the new ₹480 lakh — even though inventory and receivables differ by only ten days, because receivables are carried at selling price. That is the answer to "which leg first".

Cut receivable days from 60 to 45 at the new level of trading and receivables become 45 × ₹7.50 lakh = ₹337.50 lakh, a release of

Check it directly: 15 days saved at ₹7.50 lakh of revenue a day is 15 × 7.50 = ₹112.50 lakh. The two routes agree, and the cycle falls from 65 days to 50.

That one change more than covers the ₹25 lakh shortfall, and it costs no interest. It is also the change most likely to lose customers, which is the honest end of this example: the arithmetic says where the money is, and it does not say whether taking it is a good idea.

Where this fits in CB1

This page explains one idea from CB1 Business Finance. The full CB1 syllabus, with what each part is examined on, sits on the course page, and past-paper style mock exams with full solutions are where you find out whether the idea has stuck under time pressure.

Other CB1 topics explained

• Why financial reporting is regulated, and who it is regulated for
• Share capital and loan capital: why each source costs what it does
• Leasing against buying, and the only comparison that settles it
• Profit is not cash, and why a growing company can run out of money
• Return on capital employed, and the two things that drive it
• Gearing: why borrowing magnifies a shareholder return in both directions
• Modigliani-Miller: why gearing does not create value, and what does
• Dividend irrelevance, and the four reasons dividends still matter
• The cost of capital, and why a project must beat the whole pot
• NPV against IRR, and the three times IRR gives the wrong answer
• Valuing a company: discounted cash flow against comparable multiples
• Synergies and the takeover premium: who actually gets the gain
• Company tax in an appraisal, and the relief that reverses the answer
• Interest rate swaps: fixing a floating cost, and where the saving comes from
• Hedging currency risk: the forward contract and the money-market hedge

Stuck on a term rather than the idea? The actuarial glossary defines the notation used above. If something here is wrong or unclear, tell us — these pages get corrected.