Working capital is the amount of money which is invested in the current assets or short-term assets of the business to run the business on daily basis. This money is used to pay expenses like staff wages and utility bills etc. However, most of this money is used to buy goods for resale (except those businesses where only services are sold). Ideally, business will sell this inventory quick enough, at a profit, to pay business running expenses with the profit made and original amount will be reinvested in the products/inventory and this cycle goes on.
For example, a business buys products to resell at a cost of £10,000. If the business can sell these products for a profit of, say £3,000, and receives the money in time, it will be able to pay its other expenses e.g., rent, rates, electricity bill and staff wages from the profit of £3,000 and reinvest the original £10,000 in the stock. The process of spending money on stock and then receiving the money back is known as operating cash cycle (OCC) or cash conversion cycle (CCC). However, if it takes it too long to sell the stock, then the business will need to arrange more money to pay its expenses and to buy inventory if there are other customers willing to buy the products from the business. This extra money is usually an overdraft facility which has high rate of interest. This increases the expenses of the business and reduces the profit it makes. Therefore, it is important that businesses are able to sell their inventory quickly.
Operating cash cycle is a cycle which starts at the point where money (working capital) leaves the business for the purchase of stock /inventory and the circle is completed when the money re-enters the business after selling that stock. In other words, it gives us the number of days which it takes the business to receive the money back which it invested in the goods to resell.
For example, if a business buys the good for cash on 1st January 2021 and sells the goods for cash on 31 January 2021, its OCC will be 31 days. However, if it sells the stock by 28 February 2021, then the OCC will be 59 days (31+28). In this case, the OCC is simply “the time it takes the business to sell its inventory” which is also called Inventory Days ( The full title is “Average Inventory Turnover period” but why bother when you can say the same thing with fewer words??? 😉)
However, this cycle (OCC) can get complicated when the business is buying and/or selling on credit. Let’s look at few examples to understand this issue.
Scenario 1
A business buys inventories on credit on 1st January 2021 and sells those on 31st January 2021. The Inventory Days are 31. However, the supplier of the goods has also allowed a 15-day credit period and money does not leave the business until 15 January 2021. In this case, the money will be out of business from 16 January 2021 to 31st January 2021, therefore, the OCC is 16 days.
Scenario 2
A business buys inventories on credit on 1st January 2021 and sells those on 31st January 2021. The Inventory Days are 31. However, the supplier of the goods has also allowed a 30-day credit period and money does not leave the business until 30 January 2021. In this case, the money will be out of business for only one day, hence, the OCC is 1 day.
At this stage, it is worth mentioning that the time period allowed by the supplier to pay back the money owed for the stock is called Payable Days (full term-Average Payable Payment Period). We can also calculate OCC in the above examples by deducting Payable Days from Inventory Days i.e.,
Scenario 3
A business buys inventories on credit on 1st January 2021 and sells those on 31st January 2021. The Inventory Days are 31. However, the supplier of the goods has also allowed a 2-month credit period and money does not leave the business until 1 March 2021. In this case, the business receives the money from its customers before even paying for the goods and then it can keep that money for additional 28 days before paying its suppliers.
A negative OCC means that the business never spends money on its working capital, and it enjoys suppliers’ money for 27 days. A negative OCC is as good a possibility as a positive one, however, there are only few sectors where it can be witnessed.
This may seem too good to be true, however, there are many businesses in the UK which enjoy a situation like this where they get to keep this extra cash which belongs to the suppliers but is used to pay business’s running expenses e.g., paying staff. All the big supermarkets in the UK are examples of this business arrangement. Tesco Plc has inventory days of around 30 whereas its payable days are around 90, which makes its OCC a negative 60. This is an example of excellent working capital management (or may be an example of abuse of power over its suppliers!!!)
Some data may look financially very good, but business ethics should be followed when dealing with stakeholder. Few years ago, Tesco Plc was paying its suppliers in 180 days which made its suppliers cry out loud. The news went viral, and the social pressure pushed Tesco Plc to decrease the payment terms to 90 days.
It is time to incorporate the third element of the working capital cycle, Receivable Days (Average Receivable Collection Days). As it is possible to get credit from a supplier, it is also quite normal for business to allow its customers to buy on credit. This means that it will take longer to receive the cash for the goods sold increasing the OCC days which can put extra pressure on the business finances. However, in the current business environment, where there is a stiff competition, businesses do have to offer credit to its customers to keep them and to lure more customers. Let’s look at few scenarios with credit sales now.
Scenario 4
A business buys inventories on credit on 1st January 2021 and sells those on 2-month credit on 31st January 2021. The supplier of the goods has also allowed a 15-day credit period and money does not leave the business until 15 January 2021. In this case,
1. The business pays its supplier on 16 January – Payable Days are 15.
2. The business sells the inventory on 31 January – The Inventory Days are 31.
3. The business receives the money from customers on 1st March 2021 – Receivable Days are 59 (28+31).
In a complicated situation like this, it is easier to use the equation below to work out the OCC rather than counting the days
Operating Cash Cycle = Inventory Days (31) + Receivable Days (59) – Payable days (15)
In Scenario 4, business will not be able to recover the money it has invested in the products (plus profits if any) for 75 days which means it will need to arrange more cash to pay its running expenses and to buy more inventory.
Scenario 5
A business buys inventories on credit on 1st January 2021 and sells those on 2-month credit on 31st January 2021. However, the supplier of the goods has allowed a 3-month credit and the payment for the goods is made on 31 March 2021. In this case,
Operating Cash Cycle = Inventory Days (31) + Receivable Days (59) – Payable days (90)
The ultimate objective of the working capital management is to bring OCC closer to zero ( or even negative which can increase the profitability of the business in the long term as business will not pay interest on the extra finance needed for working capital. However, more importantly, it can enhance the liquidity of the business which means a business is able to pay its expenses when they fall due. Many businesses have been closed down due to poor working capital management and a long OCC is the main reason behind it. A longer OCC also require businesses to invest more in their working capital. I will explain this in another article.
This article is written by Raja Mizan who is a senior lecturer in accounting & finance in a UK university. He is an ACCA member and also runs his own accountancy practice RMR Accountants & Business Advisors.