Financial literacy and accountingModule 2, lesson 6 of 19
Working capital, inventory and receivables
What working capital is, how inventory, receivables and payables tie up or free cash, how to calculate the cash conversion cycle, and why growth can drain cash.
In this lesson
- Calculate working capital and operating working capital from a balance sheet.
- Calculate receivable days, inventory days and payable days.
- Calculate the cash conversion cycle and explain what it measures.
- Show how growth, or slower collection from customers, ties up cash even in a profitable business.
Builds on
- Accrual accounting and cash accountingReceivables and payables exist because accrual accounting records sales and costs before cash moves.
- Assets, liabilities and equityWorking capital is built from current assets and current liabilities.
On this page
In simple terms
A business needs more than factories and machines to operate. It needs stock on the shelves, it often waits to be paid by customers, and it often takes time to pay its own suppliers. The money tied up in these day-to-day items is its working capital.
- Inventory (stock): raw materials, work in progress and finished goods not yet sold.
- Receivables (debtors): money customers owe for sales already made.
- Payables (creditors): money the business owes its suppliers.
Inventory and receivables tie cash up. Payables free it, because suppliers are in effect lending the business money until the bills are paid.
Measuring it
Working capital = current assets − current liabilities
Operating working capital = receivables + inventory − payables
Working capital includes cash and short-term loans; operating working capital leaves them out and looks only at the items that come from running the business. Analysts use the operating version to see how much money the business itself ties up.
Rupee amounts are hard to compare across companies of different sizes, so each item is often turned into a number of days:
Receivable days = receivables ÷ revenue × 365
Inventory days = inventory ÷ cost of goods sold × 365
Payable days = payables ÷ cost of goods sold × 365
Cash conversion cycle = inventory days + receivable days − payable days
Receivable days use revenue because receivables are recorded at selling prices; inventory and payables use cost of goods sold because they are recorded at cost.
Worked example
Worked example: A made-up manufacturer's year
Godavari Fans (₹ crore): revenue 365, cost of goods sold 255.5, receivables 60, inventory 42, payables 28.
| Receivable days: 60 ÷ 365 × 365 | 60 days |
|---|---|
| Inventory days: 42 ÷ 255.5 × 365 | 60 days |
| Payable days: 28 ÷ 255.5 × 365 | 40 days |
| Cash conversion cycle: 60 + 60 − 40 | 80 days |
| Operating working capital: 60 + 42 − 28 | ₹74 crore |
On average, cash Godavari spends on materials takes 80 days to come back from customers.
Why growth uses cash
If a business grows and its days measures stay the same, receivables, inventory and payables all grow with it, and so does the cash tied up.
Worked example: Godavari grows 20%
Next year revenue and costs rise 20%, and the days measures do not change.
| Receivables: 60 × 1.2 | ₹72 crore |
|---|---|
| Inventory: 42 × 1.2 | ₹50.4 crore |
| Payables: 28 × 1.2 | ₹33.6 crore |
| Operating working capital: 72 + 50.4 − 33.6 | ₹88.8 crore |
| Extra cash tied up by growth: 88.8 − 74 | ₹14.8 crore |
That ₹14.8 crore has to come from profits, borrowing or new shares before the growth pays off. Fast growth in a business with a long cash conversion cycle can strain its finances, as the profit compared with cash flow lesson showed.
The same effect works in reverse when collection slows. If Godavari's customers started taking 90 days to pay instead of 60, with revenue unchanged, receivables would rise from ₹60 crore to ₹90 crore, absorbing ₹30 crore of cash without a single extra sale.
Short and negative cycles
Some businesses have very short, or even negative, cash conversion cycles. A supermarket sells most of its stock within days for cash, but may pay its suppliers weeks later, so suppliers fund much of its stock. A company that takes payment in advance, such as a coaching institute or a subscription service, also has customers financing it. Businesses like these can grow without needing much extra cash for working capital, which is a real advantage.
Businesses that make large, slow products, such as heavy machinery or infrastructure projects, often have long cycles and need large amounts of working capital.
Why it matters
Working capital explains much of the gap between profit and cash in a growing company. It is also an early warning system: when receivables or inventory grow much faster than sales, customers may be struggling to pay, stock may be piling up unsold, or revenue may be recorded too early. Comparing days measures over several years, and with similar companies, is one of the most useful checks an investor can make with a balance sheet.
Limitations
- Balance sheets are snapshots at the year end. Seasonal businesses can look very different at other times of year; some analysts use averages of opening and closing balances.
- Payable days are strictly based on purchases rather than cost of goods sold, but purchases are rarely reported, so cost of goods sold is used as an approximation.
- A short cycle is not automatically good: stretching suppliers too far can damage relationships and supply.
- Working capital norms differ greatly between industries, so compare companies with their peers.
Common mistakes
- Thinking more working capital means more financial strength. Large balances of stock and receivables can mean cash is stuck, not safe.
- Ignoring working capital when judging growth. Growth that needs a lot of working capital needs a lot of financing.
- Comparing days measures across industries. A retailer and a machinery maker will never look alike.
- Missing a slow rise in receivable days. A few extra days each year can add up to a large amount of cash.
Try it yourself
- From any listed company's annual report, note revenue, cost of goods sold (cost of materials and purchases, adjusted for changes in inventory), receivables, inventory and payables for two years.
- Calculate receivable, inventory and payable days, and the cash conversion cycle, for each year.
- Did the cycle get longer or shorter? What does the management discussion section of the report say about it?
Key takeaways
- Working capital = current assets − current liabilities. Operating working capital focuses on receivables plus inventory minus payables.
- Receivable days, inventory days and payable days turn those balances into time, which makes companies of different sizes comparable.
- Cash conversion cycle = inventory days + receivable days − payable days. It is roughly how long cash is tied up in each round of business.
- When a business grows, its working capital usually grows too, which uses cash even when profit is rising.
- Receivables or inventory growing much faster than sales is a signal to investigate.
Check your understanding
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Terms used in this lesson
- Working capital
- Current assets minus current liabilities. Its operating part, receivables plus inventory minus payables, is the money tied up in day-to-day business.
- Inventory
- Goods a business holds to sell or to use in production, including raw materials, work in progress and finished goods.
- Receivables
- Money owed to a business by customers who have bought on credit and not yet paid.
- Payables
- Money a business owes its suppliers for goods and services bought on credit.
- Cash conversion cycle
- Inventory days plus receivable days minus payable days. Roughly how long cash is tied up in each round of buying, making and selling.
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This lesson is general education, not investment advice. Examples use made-up or clearly dated figures to explain ideas; they are not recommendations. Read the disclaimer.