What is the Working Capital Cycle?
The Working Capital Cycle measures the efficiency at which a company can convert its current operating assets into cash on hand.
How Does the Working Capital Cycle Work?
The working capital cycle monitors the operational efficiency and nearterm liquidity risk of a given company.
The working capital cycle, or “cash conversion cycle,” counts the number of days needed by a company to fulfill its unmet current operating liabilities and collect the cash proceeds from customers on its earned revenue.
By monitoring a company’s working capital cycle metric, the inefficiencies in its business model and opportunities for improvement for value creation can be understood.
Therefore, the working capital cycle is a practical method to analyze the operating efficiency and liquidity of a particular company, including its nearterm risks.
In practice, the most common use cases for which corporations and investors alike measure the working capital cycle metric for include:
 Historical Trend Analysis → The trajectory in the working capital cycle can be tracked to confirm that a company’s operating efficiency is moving in the right direction.
 Industry Benchmark Analysis – The working capital cycle of a particular company – including each individual component – can be compared to the industry average (or sector) to determine its relative standing with regard to its industry peers.
 Liquidity Analysis → Since the change in net working capital (NWC) impacts free cash flow (FCF), measuring the working capital cycle is a method used to understand the current financial state of a company in terms of liquidity risk. A prolonged working capital cycle implies more cash is tied up in working capital, resulting in less free cash flow (FCF) and the necessity to perhaps consider raising external financing.
How to Calculate the Working Capital Cycle
The process to calculate the working capital cycle can be broken into five steps.
 Calculate Days Inventory Outstanding (DIO) → The days inventory outstanding (DIO), or “Inventory Days,” is the estimated time a company needs to replace its inventory.
 Calculate Days Sales Outstanding (DSO) → The days sales outstanding (DSO), or “A/R Days”, is the estimated number of days needed by a company to collect cash from customers who paid on credit.
 Determine Operating Cycle → The operating cycle is the sum of a company’s days inventory outstanding (DIO) and days sales outstanding (DSO).
 Calculate Days Payable Outstanding (DPO) → The days payable outstanding (DPO), or “A/P Days,” is the approximate number of days it requires a company to meet its unpaid invoices owed to suppliers.
 Calculate Working Capital Cycle → The final step to compute a company’s working capital cycle is to deduct the operating cycle by days payable outstanding (DPO).
Components of the Working Capital Cycle
If a company’s net working capital (NWC) increases, its free cash flow (FCF) declines, while an increase causes its free cash flow to rise.
 Increase in Net Working Capital (NWC) → Less Free Cash Flow (FCF)
 Decrease in Net Working Capital (NWC) → Greater Free Cash Flow (FCF)
General Rules of Thumb
 Increase in Accounts Receivable and Inventory → Cash Outflow (“Use”)
 Increase in Accounts Payable → Cash Inflow (“Source”)
 Decrease in Accounts Receivable and Inventory → Cash Inflow (“Source”)
 Decrease in Accounts Payable → Cash Outflow (“Use”)
Working Capital Cycle Formula
The working capital cycle formula is as follows.
The components of the working capital cycle metric are each listed in the following section.
 Days Inventory Outstanding (DIO) = (Average Inventory ÷ Cost of Goods Sold) × 365 Days
 Days Sales Outstanding (DSO) = (Average Accounts Receivable ÷ Revenue) × 365 Days
 Operating Cycle = Days Inventory Outstanding (DIO) + Days Sales Outstanding (DSO)
 Days Payable Outstanding (DPO) = (Average Accounts Payable ÷ Cost of Goods Sold) × 365 Days
What is a Good Working Capital Cycle?
The working capital cycle matters because the change in net working capital (NWC) impacts a company’s free cash flow (FCF) profile and liquidity.
For the most part, a shorter working capital cycle is perceived positively as a sign of operational efficiency, and vice versa for a longer cycle.
 Shorter Conversion Cycle → The shorter the working capital cycle, the less time a company needs to convert its operating current assets into cash on hand.
 Longer Conversion Cycle → On the other hand, a longer working capital cycle signifies inefficient business practices and poor cash management. If there is a considerable time lag between the date on which revenue is “earned” (and recognized) and the date of cash collection, there are likely inefficiencies that must be fixed.
If the working capital cycle is trending downward relative to that in the past, that tends to be viewed as a positive sign, whereas upward movement points towards operational inefficiencies.
How to Improve the Working Capital Cycle
The core drivers that can improve the working capital cycle of a company include the following factors:
Working Capital Levers  Description 

Reduction in Days Inventory Outstanding (DIO) 

Contraction in Days Sales Outstanding (DSO) 

Extension in Days Payable Outstanding (DPO) 

Nuances in Interpreting Working Capital Days
The underlying drivers of the working capital metric must be analyzed to confirm the validity of the findings.
 Increase in A/R Days → The receivables of a company could increase substantially after a shift in its business model, where customers can now pay in installment payments. While the pace of the cash conversion might have declined, the tradeoff could be worth the increase in nearterm liquidity risk.
 Increase in Days Payable → A company’s days payable outstanding (DPO) is normally a positive sign, unless the extension stems from its inability to pay its suppliers or vendors on time. Said differently, sometimes, the company cannot meet its shortterm obligations even if it wanted to because of insufficient cash, i.e. the “stretching” of payables was not by choice.
Working Capital Cycle Calculator
We’ll now move to a modeling exercise, which you can access by filling out the form below.
Working Capital Cycle Calculation Example
Suppose we’re tasked with calculating the working capital cycle of a company to measure its operational efficiency on a pro forma basis.
In Year 1, the company had the following working capital metrics, which will serve as our starting point.
Working Capital Components
 Days Inventory Outstanding (DIO) = 20
 Days Sales Outstanding (DSO) = 80
 Days Payable Outstanding (DPO) = 40
Given those initial assumptions, a potential interpretation – in the absence of industry data – is that the weak point in the company’s business model is the collection of cash from customers who paid on credit.
On the other hand, the company’s working capital management for inventory and payables seems reasonable.
In Year 1, the company’s working capital cycle is 60 days, which is the time needed to convert inventory into cash, collect cash from credit purchases, and fulfill its outstanding payables to suppliers or vendors.
 Working Capital Cycle = 20 DIO + 80 DSO – 40 DPO = 60 Days
Starting in Year 2, we’ll insert a step function based on the following assumptions on the yearoveryear (YoY) change in each metric.
Working Capital Step Function
 Days Inventory Outstanding (DIO) = (0.5)
 Days Sales Outstanding (DSO) = (1.0)
 Days Payable Outstanding (DPO) = 2.0
Since inventory days and A/R days are projected to decrease, the impact on working capital days should be positive (i.e. more operational efficiency). In contrast, the company’s days payable are expected to increase.
By the end of the forecast period, the company’s working capital cycle decreased by 14 days, from 60 days to 46 days in Years 1 and 5, respectively.