The working capital cycle explained

The three parts of the cycle

• Days inventory outstanding (DIO): how many days stock sits before it is sold.
• Days sales outstanding (DSO): how many days customers take to pay after the sale.
• Days payables outstanding (DPO): how many days you take to pay suppliers.

Working capital cycle = DIO + DSO − DPO.

Your supplier's credit funds part of the cycle. The rest is funded by your capital, an overdraft or a cash credit limit. For a definition of the underlying term, see working capital in the glossary.

How to calculate each number

Use one year of figures from your Profit & Loss and Balance Sheet. Averages (opening plus closing, divided by two) give a fairer picture than the closing figure alone.

• DIO = average stock ÷ cost of goods sold × 365
• DSO = average trade receivables (sundry debtors) ÷ credit sales × 365
• DPO = average trade payables (sundry creditors) ÷ purchases × 365

Use figures without GST where possible, or with GST on both sides, so that you compare like with like.

Worked example: an electrical goods distributor

• DIO = 69,00,000 ÷ 4,20,00,000 × 365 ≈ 60 days
• DSO = 78,90,000 ÷ 4,80,00,000 × 365 ≈ 60 days
• DPO = 35,30,000 ÷ 4,30,00,000 × 365 ≈ 30 days

Cycle = 60 + 60 − 30 = 90 days. The business needs to fund about 90 days of cost, about ₹1,03,50,000 (4,20,00,000 ÷ 365 × 90), from its own money or borrowings.

What a 15-day improvement is worth

Daily cost of goods sold in the example is about ₹1,15,000. Every day removed from the cycle frees roughly that much cash.

• Cutting DSO from 60 to 50 days releases about ₹13,15,000 (10 days of sales at ₹1,31,500 a day).
• Cutting DIO from 60 to 55 days releases about ₹5,75,000.

At an overdraft rate of, say, 11% a year, ₹18,90,000 less borrowing saves around ₹2,08,000 of interest a year, with no change in sales.

Ways to shorten the cycle

Reduce DSO

• Put due dates on every invoice and follow up before the due date, not after.
• Use a clear credit control policy with limits and a stop-supply rule.
• Send party statements regularly so disputes surface early.

Reduce DIO

• Track inventory turnover and dead stock by item, not just in total.
• Set reorder levels from real sales rather than gut feel.

Use DPO carefully

• Negotiate longer terms with large suppliers, but do not stretch payments beyond what is agreed. Purchases from micro and small enterprises carry a legal payment time limit and an income-tax consequence if paid late.

Reading the trend, not just the number

One year's cycle is a snapshot. The useful view is month by month, worked out on a rolling basis. If DSO goes from 52 to 58 to 64 days over three quarters, collection is slipping even if sales are growing. If DIO rises while sales are flat, purchases are running ahead of demand.

Seasonal businesses should compare the same month across years. A fan distributor will always hold more stock in February than in August; the question is whether this February is worse than last February.

Also check what is funding the cycle. Rising bank borrowing alongside a longer cycle means the business is borrowing to finance slow customers and slow stock. A rising cycle funded by stretched supplier payments is riskier still, because suppliers can tighten terms at short notice.

Watching the cycle with Tally and Cashflow OS

All the inputs above are already in TallyPrime. Cashflow OS syncs that data and shows the Profit & Loss, Balance Sheet and bill-wise outstanding with ageing on your phone or the web, for any financial year or a custom date range. Stock and item summaries help you spot slow items. Export the reports to Excel to work out DSO, DIO and DPO month by month and see whether the cycle is getting shorter.