Fundamental analysisModule 4, lesson 16 of 48
Working capital efficiency
How to track inventory, receivable and payable days and the cash conversion cycle over time, and the warning signs, such as receivables growing faster than sales.
In this lesson
- Calculate inventory, receivable and payable days and the cash conversion cycle.
- Track these measures over several years and against peers.
- Work out how much cash a change in working capital ties up or releases.
- Recognise working capital warning signs and their possible causes.
Builds on
- Working capital, inventory and receivablesThat lesson introduces inventory, receivables, payables and the cash conversion cycle.
- Free cash flow and cash conversionChanges in working capital are one of the main reasons free cash flow differs from profit.
On this page
In simple terms
Working capital is the money tied up in running a business day to day: inventory waiting to be sold, receivables waiting to be collected, minus payables the company has not yet paid. The working capital lesson explains the basics.
For an analyst, the useful step is to turn these balance sheet figures into days, so you can compare them across years and with competitors. Trends in these day counts are often one of the earliest signs that something is changing in a business.
The three day measures
inventory days = inventory ÷ cost of goods sold × 365 receivable days = trade receivables ÷ revenue × 365 payable days = trade payables ÷ cost of goods sold × 365
cash conversion cycle = inventory days + receivable days − payable days
Use average balances for the year where possible. Some analysts use revenue for all three; what matters is consistency.
- Inventory days: how long goods sit before being sold.
- Receivable days: how long customers take to pay.
- Payable days: how long the company takes to pay suppliers.
- Cash conversion cycle: how many days of operations the company must finance itself between paying suppliers and collecting from customers.
Tracking the trend
Worked example: A made-up company over three years
Deccan Pumps, in ₹ crore:
| Year 1 | Year 2 | Year 3 | |
|---|---|---|---|
| Revenue | 1,000 | 1,100 | 1,150 |
| Cost of goods sold | 700 | 770 | 800 |
| Inventory | 115 | 140 | 175 |
| Receivables | 165 | 215 | 270 |
| Payables | 96 | 100 | 105 |
| Inventory days, year 1: 115 ÷ 700 × 365 | 60 days |
|---|---|
| Inventory days, year 3: 175 ÷ 800 × 365 | 80 days |
| Receivable days, year 1: 165 ÷ 1,000 × 365 | 60 days |
| Receivable days, year 3: 270 ÷ 1,150 × 365 | 86 days |
| Payable days, year 1: 96 ÷ 700 × 365 | 50 days |
| Payable days, year 3: 105 ÷ 800 × 365 | 48 days |
| Cash conversion cycle, year 1: 60 + 60 − 50 | 70 days |
| Cash conversion cycle, year 3: 80 + 86 − 48 | 118 days |
Revenue grew 15% in two years, but receivables grew 64% and inventory 52%. The cash cycle lengthened by 48 days. Deccan may be offering longer credit to win sales, its customers may be struggling, or products may not be selling as planned.
How much cash does it tie up?
Each extra day in the cycle ties up roughly one day's worth of sales (or costs) in cash. For Deccan in year 3, one day of revenue is about 1,150 ÷ 365 = ₹3.2 crore, so 48 extra days tie up roughly ₹150 crore. That cash had to come from somewhere: lower free cash flow, more borrowing, or both. This is why a business can report rising profit and falling cash, as the profit and cash flow lesson shows.
Warning signs and their causes
| Sign | Possible causes |
|---|---|
| Receivables growing much faster than revenue | Customers paying slowly, longer credit to win sales, sales recorded too early |
| Inventory growing much faster than sales | Demand weaker than expected, obsolete stock, stock built ahead of a price rise |
| Payable days rising sharply | Bargaining power over suppliers, or the company struggling to pay |
| Payable days falling sharply | Suppliers demanding faster payment, perhaps because they see credit risk |
| Large "other current assets" or advances growing fast | Money paid out that is not clearly earning anything; read the notes |
None of these proves a problem. Each needs an explanation, and the MD&A and notes are where to look. If the explanation is vague, be more cautious.
Context matters
Normal working capital differs enormously between industries. A supermarket may collect cash at the till, hold stock for a few weeks and pay suppliers after a month or two, giving a negative cash cycle: suppliers effectively fund it. A capital goods maker may hold inventory for months and wait months to be paid. Compare a company with its own history and with close peers, not with businesses that work differently.
Seasonal businesses can also show very different figures depending on the balance sheet date.
Why it matters
Working capital trends often change before profits do. A lengthening cash cycle can be the first sign of weakening demand, a customer in trouble, aggressive sales practices, or accounting problems. It also directly affects free cash flow: a company whose cycle keeps lengthening needs ever more money just to stand still.
Limitations
Year-end figures may not represent the whole year, and companies can manage them, for example by collecting receivables or delaying purchases just before the balance sheet date. Factoring or selling receivables can make receivable days look shorter while the underlying credit has not changed; check the notes for such arrangements. Use several years and look for consistent patterns.
Common mistakes
- Looking at a single year rather than the trend.
- Comparing working capital across very different industries.
- Assuming rising receivables simply mean rising sales.
- Treating higher payable days as purely good news.
Try it yourself
Choose a listed manufacturer and use five years of its annual reports.
- Calculate inventory days, receivable days and payable days for each year.
- Calculate the cash conversion cycle and note the trend.
- Work out roughly how much cash the change in the cycle has tied up or released.
- Read the MD&A for any explanation, and decide whether it convinces you.
Key takeaways
- Inventory days, receivable days and payable days convert balance sheet items into days of sales or costs, so they can be compared across years and companies.
- The cash conversion cycle is inventory days plus receivable days minus payable days, the number of days cash is tied up in operations.
- A lengthening cycle ties up cash. Even a few extra days on a large business can absorb a lot of money.
- Receivables growing much faster than revenue, or inventory piling up, are common warning signs of slowing demand, weak customers or aggressive accounting.
- Stretching payments to suppliers improves the cycle but can signal cash strain if it goes too far.
Check your understanding
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Terms used in this lesson
- 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.
- Receivables
- Money owed to a business by customers who have bought on credit and not yet paid.
- Inventory
- Goods a business holds to sell or to use in production, including raw materials, work in progress and finished goods.
- Payables
- Money a business owes its suppliers for goods and services bought on credit.
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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.