Working Capital Ratio & Cash Conversion Cycle

What is the working capital ratio?

Your working capital ratio (also referred to as your current ratio) is a measure of your company’s liquidity. It measures if you have enough assets to cover short-term expenses like payroll and your accounts payable. The working capital ratio is calculated by dividing your current assets by your current liabilities.    

Working capital ratio = current assets / current liabilities

Current assets include:

  • cash
  • accounts receivable
  • raw materials
  • inventory

Current liabilities include:

  • accounts payable
  • taxes
  • wages
  • interest owed
calculate working capital ratio example using current assets and current liabilities

Generally, to maintain a healthy liquidity you would aim for a working capital ratio of 1.5 to 2.0. If you have a higher working capital ratio it may suggest you aren’t maximizing your return on assets and revenue. A lower working capital ratio is a warning sign that the business may not be able to easily pay all of its short term bills and payroll.

For most companies, working capital will fluctuate. Many factors can influence your working capital, including large bill or debt payments and seasonal changes in sales.

What is the working capital cycle?

Your working capital cycle differs from the working capital ratio in that it reflects the length of time it takes to convert your products or services into cash. This refers to the cycle your cash makes. Spend cash > Buy Inventory > Sell Inventory > Get cash back from customer. To increase cash flow, it’s extremely advisable to shorten your working capital cycle.

working capital flow chart showing the four phases of the working capital cycle

The less time that there is between paying for an expense and receiving money from a customer, the better your cash flow.

This can look different depending on what industry you operate in. For example, while ecommerce businesses don’t have invoicing or the accounts receivable you might find in professional services, they do likely have a delay between buying product and selling it. Although the length of your cycle can vary depending on what you sell, the most efficient companies would have a cash-to-cash cycle of less than one month.

The 4 phases of the working capital cycle are:

  1. Cash: The goal is to have healthy cash balance by managing cash inflows and outflows of your business
  2. Payables: The payment terms for money owed for goods or services provided to you suppliers and/or vendors
  3. Inventory: How long it takes to sell your inventory (if applicable)
  4. Receivables: The payment terms for money owed for goods or services you sell

Cloud CFO Tip: We suggest having a minimum of 3 months working capital on reserve. If you’re hit with an unexpected cash crunch you want to feel confident you can pay employees, vendors, lenders and investors on time. Plus, if you’re always worried about having the cash reserves to meet those basic obligations, it becomes hard to focus on growing new business.

4 ways to improve your working capital

Here are a few tips to improve your ratio at each stage of the working capital cycle:

1). Optimize bill payments: on the other side of your cycle, if you have suppliers that offer early-pay discounts, choose periods with increased revenue to pay your biggest expenses and to take advantage of early-payment discounts.

Cloud CFO Tip: Get creative with presales. By collecting cash before you pay for raw materials or inventory, you are shortening your working capital cycle and have a better chance of maintaining that optimal working capital ratio.  

2). Run frequent inventory forecasts: monthly is ideal, while considering any seasonal fluctuations.

Cloud CFO Tip: Slice your date by SKU, sales channels, and locations to get more accurate forecasts. These give you better data to base decision-making on to optimize inventory.

3). Reduce inventory and carrying costs: stock only those items you are confident will sell quickly. Sell off stale inventory to reduce dead stock and raise cash.

Cloud CFO Tip: Bundle your dead stock with faster-selling inventories.  Like all tactics to empty dead stock shelves, your profit margins will take a hit. To recover as much revenue as possible, bundle dead stock with highly popular items that are likely to sell anyway. Pairing a hot item with a stagnant product has the added bonus of upselling your other items.

4). Improve your accounts receivable

Cloud CFO Tip: One way to improve cash flow is to offer an early payment discount to clients or customers that pay before the terms set in your invoice. Even with the discount it’s better for cash flow to have it in-hand compared to waiting for late invoices. Think 2% savings if you pay before the term. A 2% discount is common if customers pay you within 10 days of invoice.

All these tips ultimately help improve your cash conversion cycle.

What is the cash conversion cycle?

If you operate in ecommerce, manufacturing or consumer goods, you may find the cash conversion cycle (CCC) is a more useful measure of liquidity than the working capital ratio. The cash conversion cycle measures how quickly your company turns inventory into cash. It calculates your inventory into cash within a set time period.

An unsustainable CCC is a red flag that you may be seeing issues with liquidity and should signal a need for improvements to your working capital.

Cash conversion cycle formula

The cash conversion cycle formula is: Days Inventory Outstanding (DIO) + Days Sales Outstanding (DSO) – Days Payables Outstanding (DPO) = Cash Conversion Cycle (CCC)

Cash Conversion Cycle (CCC) = DIO + DSO – DPO

Days Inventory Outstanding = (Inventory/COGS) x Days in Period

days inventory outstanding formula for cash conversion cycle: Days Inventory Outstanding = (Inventory/COGS) x Days in Period

Days Sales Outstanding = (Average Accounts Receivable/Revenue) x Days in Period

days sales outstanding formula for cash conversion cycle: Days Sales Outstanding = (Average Accounts Receivable/Revenue) x Days in Period

Days Payables Outstanding = Average Accounts Payable/COGS) x Days in Period

days payables outstanding formula for cash conversion cycle: Days Payables Outstanding = Average Accounts Payable/COGS) x Days in Period

You can find this information on your income statement and balance sheet. Generally, the lower your CCC, the better. A lower cash conversion cycle is an indicator of a faster inventory-to-cash process. Meaning your working capital is tied up for a shorter amount of time and your business has greater liquidity, AKA, better cash flow.

The CCC is particularly useful if you’re comparing it year over year (YoY) to improve business performance or if you’re comparing it to competitors. It can be used along with the working capital ratio to improve your company’s liquidity and overall financial health.

Need help calculating your working capital ratio or cash conversion cycle? Contact us to learn more about our NetSuite accounting services and fractional CFO services.

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