Working capital and the cash conversion cycle

Key takeaways

• Accounting net working capital is current assets less current liabilities; operating working capital excludes cash, debt and other financing items.
• DSO measures how long customers take to pay, DIO how long inventory sits, and DPO how long the company takes to pay suppliers.
• Cash conversion cycle = DSO + DIO - DPO: the days of operations the company must finance itself.
• At constant days, working capital grows in proportion to revenue, so fast growth can absorb more cash than it generates in profit.
• Each day of DSO is worth one day of revenue in cash, and each day of DIO or DPO one day of cost of goods sold.
• An M&A working capital peg sets a normal level of working capital, usually a trailing average; the price is adjusted dollar for dollar for any difference at closing.

Two definitions of working capital

The accounting definition of net working capital (NWC) is simply current assets less current liabilities. It is a liquidity measure: it asks whether the company's short-term resources cover its short-term obligations, and lenders use it that way. But it mixes two very different kinds of item. Cash and short-term debt are financing decisions. Receivables, inventory and payables are the result of how the business operates.

For valuation, cash flow forecasting and M&A, practitioners use operating working capital, sometimes called non-cash working capital or trade working capital when limited to receivables, inventory and payables. It excludes cash and cash equivalents, short-term debt, the current portion of long-term debt, current lease liabilities, and usually income taxes payable and dividends payable. What remains is the capital the operating business needs to function.

The reason for the exclusion is to avoid double counting. In a discounted cash flow model, cash is added to enterprise value separately and debt is subtracted separately. If they were also inside working capital, a change in the cash balance would show up as a working capital cash flow, which is circular.

DSO, DIO and DPO

Balances in dollars are hard to compare across companies or over time as a business grows. Converting them into days of activity solves both problems. Each metric divides a balance by the daily flow that creates it.

Days sales outstanding (DSO) divides receivables by daily revenue. It is the average number of days customers take to pay. Days inventory outstanding (DIO), also called days inventory on hand, divides inventory by daily cost of goods sold, because inventory is carried at cost. It is the average number of days goods sit before being sold. Days payable outstanding (DPO) divides payables by daily cost of goods sold. It is the average number of days the company takes to pay its suppliers.

Using COGS for DPO is a convention and an approximation: payables arise from purchases, which differ from COGS when inventory is building or falling, and payables can include non-inventory suppliers. Some analysts use purchases (COGS plus the increase in inventory) instead. Conventions also differ on whether to use year-end or average balances and a 365 or 360 day year. None is wrong; consistency across periods and peers is what matters.

The cash conversion cycle

The cash conversion cycle (CCC) combines the three measures into the number of days between paying for inventory and collecting cash from the customer who bought it. The logic follows the physical flow. Goods arrive and sit in inventory for DIO days. They are sold on credit and the receivable is outstanding for DSO days. The supplier, meanwhile, is paid after DPO days. The company finances the gap.

A longer cycle means more capital tied up per dollar of sales. A negative cycle, where a company collects from customers before it pays suppliers, means suppliers are financing the business. Subscription businesses that bill in advance and retailers that sell for cash while paying suppliers on terms can operate this way.

The cycle is a ratio of days, not a dollar amount, because DSO is measured in revenue days and DIO and DPO in cost days. To translate a change in days into cash, multiply by the daily flow that the metric uses.

Why growth consumes cash

If a company's working capital days stay constant, its working capital balances must grow in proportion to revenue. More sales at the same DSO means more receivables. More sales at the same DIO means more inventory. Payables grow too, partly offsetting the rest. The net increase in operating working capital is a cash outflow on the cash flow statement, even though it never touches the income statement.

For businesses with a long cycle and thin margins, such as distributors, contract manufacturers and project businesses, this effect can exceed the extra profit that growth produces. The company becomes more profitable and shorter of cash at the same time, and has to borrow to fund the gap. For a lender this is the logic behind asset-based revolving credit facilities, whose availability rises with eligible receivables and inventory. For an equity investor it is a reminder that growth is only valuable if the return on the capital it absorbs exceeds the cost of that capital.

Reading working capital trends

Changes in working capital days are among the most informative signals in a set of accounts, because they often move before the income statement does. Rising DSO can mean looser credit terms offered to win sales, a customer in difficulty, or revenue booked before it is really collectible. Rising DIO can mean slowing demand, obsolete stock or deliberate stockpiling ahead of a price increase. Rising DPO can mean better supplier terms, or a company quietly stretching its suppliers because it is short of cash.

Year-end balances can also be managed. A company can hold back supplier payments in the last week of the year, push customers to pay early with discounts, or run inventory down temporarily. The result is a flattering cash flow statement and a reversal the following quarter. Comparing year-end days with quarterly or monthly averages reveals it.

The working capital peg in M&A

Private company acquisitions are commonly priced on a cash-free, debt-free basis: the buyer agrees an enterprise value, the seller keeps the cash and repays the debt, and the equity price is enterprise value less net debt. That basis assumes the business is delivered with a normal level of working capital. Without a mechanism to enforce it, a seller could collect receivables aggressively and delay paying suppliers before closing, pocketing the cash and leaving the buyer to refill working capital.

The working capital peg, or target, solves this. The purchase agreement defines working capital precisely, usually operating working capital excluding cash, debt, debt-like items and income taxes, and sets a target level. At closing, the actual working capital is compared with the peg. If it is below the peg, the price falls by the shortfall. If it is above, the price rises by the excess. The adjustment is dollar for dollar, is first estimated at closing and then trued up in a post-closing statement, typically within a few months.

The peg is usually based on a trailing twelve-month average of monthly working capital, which smooths seasonality and reflects what the business needs across a full cycle. For a seasonal business, the buyer and seller may argue for a peg based on the month of closing in prior years. For a fast-growing business the buyer may argue for a higher peg than the historical average, since the business will need more. The peg is negotiated during diligence and is one of the most frequently disputed items after closing.