Working Capital Deep Dive

Step 1: Days Sales Outstanding (DSO)

DSO measures the average number of days between recognizing a sale as revenue and actually collecting the cash for it. It's calculated by comparing the Accounts Receivable balance — the amount customers still owe — to Revenue over the same period, then expressing that ratio in days.

DSO = (Accounts Receivable / Revenue) × 365

DSO rose by roughly 6 days — the company is collecting cash from customers more slowly in Year 2 than in Year 1, relative to the pace of sales.

Step 2: Days Inventory Outstanding (DIO)

DIO measures how many days, on average, a unit of inventory sits on the balance sheet before it's sold. Inventory is carried on the books at cost, so it's compared against Cost of Goods Sold (COGS) rather than Revenue — Revenue includes the markup the company adds on top of cost, which would distort the "days" figure if used here.

DIO = (Inventory / COGS) × 365

Inventory is also turning over more slowly in Year 2 — about 11 more days of goods sitting unsold on average.

Step 3: Days Payable Outstanding (DPO)

DPO measures how many days, on average, the company takes to pay its own suppliers after receiving goods or services. Like DIO, it's measured against COGS (the cost base that generates the payable in the first place), not Revenue.

DPO = (Accounts Payable / COGS) × 365

DPO also lengthened — the company is taking longer to pay suppliers in Year 2, which on its own is a positive for cash (money stays in the business longer before going out the door).

Step 4: Cash Conversion Cycle (CCC)

The Cash Conversion Cycle nets the three metrics above into a single number: how many days, on net, cash is tied up in the operating cycle between paying suppliers and collecting from customers. Receivables and Inventory both represent cash the company is waiting to get back (added), while Payables represent supplier financing the company is currently benefiting from (subtracted).

CCC = DSO + DIO − DPO

Year 1: 43.8 + 60.8 − 48.7 = 55.9 days

Year 2: 49.8 + 71.9 − 60.8 = 60.9 days

Even though DPO also increased (which helps), the increases in DSO and DIO were larger in combination, so the CCC still lengthened by about 5 days — cash is tied up in the operating cycle for longer in Year 2 than in Year 1.

Step 5: Change in Net Working Capital (NWC)

Net Working Capital converts the same idea into a dollar figure rather than a days figure: it's the net amount of operating capital tied up in receivables and inventory, after netting out the free financing the company gets from its suppliers via payables.

NWC = Accounts Receivable + Inventory − Accounts Payable

Year 1: \$60.0m + \$50.0m − \$40.0m = \$70.0m

Year 2: \$75.0m + \$65.0m − \$55.0m = \$85.0m

ΔNWC = \$85.0m − \$70.0m = +\$15.0m

The sign convention matters here: an increase in NWC means the company has more cash locked up in operations than before — it had to fund that extra \$15.0m of receivables and inventory (net of supplier financing) out of its own pocket, so this is a use of cash of \$15.0m. Had NWC decreased instead, that would represent operating capital being released back as cash — a source of cash. This \$15.0m use of cash is consistent with the lengthening CCC found in Step 4: both are describing the same underlying fact, just in dollars versus days.

Final Results

• DSO (Year 2): 49.8 days
• DIO (Year 2): 71.9 days
• DPO (Year 2): 60.8 days
• CCC (Year 2): 60.9 days
• ΔNWC: +\$15.0m (use of cash)

This \$15.0m use of cash would be subtracted directly in an unlevered free cash flow build, alongside CapEx and D&A adjustments, before arriving at Free Cash Flow.

Would you like to explore how a working capital assumption change (e.g. tightening DSO back to Year 1 levels) would flow through into next year's Free Cash Flow?