Working capital: the money tied up in running the business

Working capital is current assets minus current liabilities — in practical terms, the money tied up in stock and unpaid customer invoices, less what you owe suppliers in the near term. It is the cash the business needs simply to keep operating, before any question of growth or profit.

The counterintuitive part, and the one that catches people out, is that growth consumes working capital. More sales means more stock bought and more invoices outstanding, both of which are paid for before the money arrives. A business can be profitable, growing, and unable to pay wages, and the explanation is always the same gap.

The cycle, and how to measure it

1. Days of stock: how long inventory sits before it sells. Stock value divided by daily cost of goods sold.
2. Days of receivables: how long customers take to pay. Outstanding invoices divided by daily sales.
3. Days of payables: how long you take to pay suppliers. Outstanding supplier bills divided by daily purchases.
4. Stock days plus receivable days minus payable days is the cash conversion cycle — the number of days your money is out of the business.
5. Multiply that by daily cost and you have the amount of cash the cycle permanently consumes. That figure is usually larger than owners expect, and seeing it is the point of the exercise.

Shortening the cycle by ten days releases cash without a single extra sale, and the three levers are unequal. Collecting faster is usually the largest and quickest — the ground covered in credit control. Holding less stock is next and takes a quarter to show. Paying suppliers later is the smallest and the most expensive if overused, because supplier goodwill is worth more than the days it buys.

Where working capital hides

• Slow-moving stock. Every item that has not sold in a year is cash sitting on a shelf, and writing it off is cheaper than pretending.
• Customers who pay late by habit. The cost is the days multiplied by daily sales, and it is usually a bigger number than any discount you would have refused.
• Deposits not taken. Asking for a percentage up front on large orders is normal in most trades and shortens the cycle immediately.
• Work in progress. Anything half-finished has consumed cost and generated nothing.
• Prepaid annual subscriptions, which move a year of cash out on one day for no operational reason.

A note on financing

This is a well-advertised problem, and searching for it produces a great many offers of working capital loans, invoice finance and lines of credit. Some of those products are legitimate and appropriate — a seasonal business bridging a predictable gap, for instance. But borrowing to fund a cycle that could be shortened is expensive, and the arithmetic above tells you which situation you are in. Work out the cycle first; the answer often removes the need for the product. We do not lend and have nothing to sell you here, which is exactly why the advice is worth what it costs.

Growth and the gap

The specific trap is worth stating plainly. Doubling sales roughly doubles the working capital requirement, and that money is needed before the growth pays for itself. A business planning a large order, a new location or a step change in volume should calculate the working capital it consumes at the same time as the profit it produces — otherwise the plan is a profit forecast attached to a cash problem, which is covered from the other direction in cash flow forecast.

Where to work it out

Ettex Sheets is where the cycle calculation belongs, since it is arithmetic you want to rerun as the inputs move; the figures come from Ettex Books, the receivables side from Ettex Invoices, and the stock side from inventory management.