How long is too long for a working capital cycle?

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Provided that they make a return on what they hand over to their suppliers, most business owners are fairly happy, but have you considered that you may be losing money through the time it takes for you to pay your suppliers and for receivables to come into your business?

Your enterprise’s working capital cycle shows the difference in time between these crucial ins and outs, and an understanding of how it works – and the cycle to which your company is operating – is crucial to business success.

What’s a normal working capital cycle?

The broad consensus among accountancy professionals is that a normal working capital cycle operates at about a two-to-one ratio, i.e. it takes twice as long to receive payment as it does for the business to pay its suppliers. This is a good rule of thumb, but it varies from one industry to the next and there may be specific reasons why it is more in your interest to have a longer or shorter cycle.

What we can agree on, though, is that the longer the cycle, the more alternative means you will need to fill the gap. Usually, this will mean short-term borrowing, which comes with interest expenses, so it’s clearly in your interest to narrow this disparity as much as is realistically possible.

Can my working capital cycle be too short?

This might lead you believe that the optimum situation would be to have a very short cycle, whereby goods and services are sold almost as soon as goods and services are bought. Though it is recommended to strive for a low ratio, some companies that achieve this give a misleading indication of how efficient they are. For example, they might be selling too low or to the wrong markets, thereby not maximising their return on investment.

It’s therefore important to research your sector. If you are a service provider and have little to no inventory, a short cycle should be achievable. Retailers have a little more breathing space, although obviously if you work in a sector like food, your stock will have a more limited shelf life.

Closing the gap

Identifying patterns in paying and receiving is crucial to establishing where your business is making and losing money, but in-house accounts teams are often too focused on day-to-day cashflow administration to manage this. Through outsourcing accounts, payable and receivable transactions can be closely monitored by a team of professionals, who can advise you on steps to take to limit your borrowing and the amount of funds gathering dust by being tied up in your working capital.