Working capital and the cash cycle

Working capital is the cash tied up in the daily operations of the business: in receivables, in inventory, less what's owed to suppliers. The cash conversion cycle is how long that capital is tied up before becoming cash again. It's the most underappreciated number in operating businesses.

Working capital — the formula

Working capital = Current assets − Current liabilities. But for analysis, the more useful definition is Operating Working Capital = Accounts Receivable + Inventory − Accounts Payable. That strips out cash and short-term debt to focus on operations.

DSO, DIO, DPO — the three ratios that compose the cycle

                Accounts Receivable                       Inventory
  DSO  =  ────────────────────────────       DIO  =  ────────────────────────
              Revenue  /  365                            COGS  /  365


                  Accounts Payable
  DPO  =  ─────────────────────────────
                  COGS  /  365

• DSO (Days Sales Outstanding) — average number of days between a sale being recorded and the cash actually being collected from the customer. AR is the receivables balance from the balance sheet; Revenue/365 is the daily revenue run-rate. Lower DSO is better — it means customers pay quickly. Industry norms: software 30-60 days, retail 5-15 days (mostly cash/card), B2B manufacturing 45-90 days, government contracting 90-180 days.
• DIO (Days Inventory Outstanding) — average number of days inventory sits in the warehouse before being sold. Inventory is the balance sheet number; COGS/365 is the daily inventory consumption rate. Lower DIO is generally better — capital is not tied up in stock. Industry norms: software near zero (no inventory), retail 30-90 days, manufacturing 60-120 days, distillers/agers years (whisky producers, wine).
• DPO (Days Payables Outstanding) — average number of days between receiving a supplier invoice and actually paying it. AP is the payables balance; COGS/365 is the daily purchases run-rate (an approximation; precise computation uses purchases, not COGS, but COGS is close enough). Higher DPO is generally better for the firm — it means using supplier credit as free financing. Industry norms: 30-45 days typical; large retailers extract 60-90+ days from suppliers as a bargaining-power advantage.

The cash conversion cycle — putting it together

  CCC  =  DIO  +  DSO  −  DPO

where:
  DIO  =  days inventory sits before being sold
  DSO  =  days from sale to cash collection
  DPO  =  days from purchase to cash payment to suppliers

Reading: CCC is the number of days the firm's own cash is tied up in
operations. The firm pays suppliers cash on day DPO; the inventory it
bought becomes a sale on day DIO; the customer pays cash on day
DIO + DSO. Net days the firm is funding operations from its own
resources = DIO + DSO − DPO.

Worked example:
  DIO = 60, DSO = 45, DPO = 30
  CCC = 60 + 45 − 30 = 75 days

The firm needs to fund 75 days of operations from its own cash. If
revenue is $1bn / year ($2.74m / day), that's roughly $205m of
working capital tied up at any moment — a material call on financing.

Reading the cycle for different industries

• Software: near-zero or negative — billed in advance, low inventory, modest payables
• Retail (great operators): negative — sell inventory before paying suppliers
• Manufacturing: 60-120 days — long production cycles, slow-paying customers
• Construction: 90-180 days+ — projects span quarters, payment milestones lag

What working capital does to growth

Growing companies often consume cash even when profitable, because each new dollar of revenue requires roughly proportional new working capital. A company growing 50% with a 90-day CCC and 20% margins will burn cash; the same company at 10% growth might be cash-rich. Growth and cash flow can diverge for healthy reasons — but you should know which is happening.