Cashflow is a constant challenge for small business owners – whether you’re selling goods or services.
The first step to addressing this challenge is by improving your understanding of working capital.
But what is a working capital cycle – and how exactly does it affect your cashflow?
What is a working capital cycle?
A working capital cycle is a measure of the time it takes to get a return on the investment that you’ve made.
Generally, as a business, you’re either selling a service or selling goods.
Regardless of which applies to you, the working capital cycle is how long it takes you to get the cash in the bank for what you have sold.
Working capital cycle in retail
In retail, the working capital cycle works like this:
- You purchase inventory.
- Depending on the suppliers that you purchase from, you may have to pay immediately or on the 20th of the following month (for instance).
- You now have stock on hand.
- You convert stock into cash by selling it and receiving payment as fast as possible.
- Delays in selling inventory lead to a longer working capital cycle and more of a cash crunch.
In retail, this is a key metric. Whether you call it sell-thru or stockturn, it’s important that you purchase your inventory sensibly. Keep your customers’ needs and wants uppermost in your mind so that stock flies out of the door rather than sitting on the shelves for weeks.
For retail businesses, the working capital cycle tells you how much capital you have in the business to cover the “gap” between when you must pay suppliers for the inventory purchased and when customers pay you for the inventory that’s sold.
Working capital cycle as a service provider
If you’re a service provider, the working capital cycle works like this:
- You agree to sell services to a customer.
- You deliver those services (this can take some time).
- You invoice your customer either at the point of agreement to provide services or at delivery of services.
- Once you’ve invoiced your customer, that amount increases your accounts receivable total (what your customers owe you).
- That money isn’t in the bank yet – it sits in your accounts receivable ledger until you’re paid.
- The customer then pays you and the cycle is complete.
The working capital cycle in a service business is about the gap between when you must pay suppliers/staff/overheads for the delivery of the service and when customers pay you for the service provided.
It’s crucial to optimise the delivery of services. Delivery in the most effective and efficient way possible actively reduces the time it takes your customers to pay for your services.
This will then improve the working capital cycle in your service business.
Reducing the working capital cycle to improve cashflow
As a business owner, you want the working capital cycle to be as short as possible. This will mean that you’re converting your investments to cash in the shortest amount of time.
But remember that you can’t improve what you can’t measure. The measure of the working capital cycle is the cash conversion cycle.
Depending on the length of your cash conversion cycle, you can free up working capital faster, meaning that cash will be available for investment in other areas of your business.
This could be funding growth, investing in different stock or paying down debt.
What could you do with a shorter working capital cycle?
If you’d like to discuss your options for achieving this, contact us here.