Working Capital

Finance · 3 min read

Working capital is the money your business needs to keep running between the time you pay for something and the time you get paid back for it. Underestimate it and you run out of cash. Most growing businesses do.

A retailer is having her best year. Sales are up 60% over last year. The team is celebrating. Three months later, she cannot make payroll.

Nothing has gone wrong with the business. The product is selling. Customers are paying their invoices on time. Profit is up. And the business is broke. This is the classic working capital crisis, and it is the single most common way that profitable, growing businesses die.

Working capital is the money a business needs to fund the gap between when it pays its bills and when it collects from its customers. The formal definition is short: current assets minus current liabilities. A more useful definition is longer. Working capital is the cash that gets tied up in inventory waiting to be sold, in receivables waiting to be collected, in payroll that has to be paid before the revenue from that work has arrived. It is the operational money of the business — separate from profit, separate from long-term investments, and absolutely critical to staying alive.

The working capital problem becomes clear when you trace a single sale through its full cycle. A retailer orders inventory in January and pays for it in February — cash out. The inventory sits on shelves through March and April — cash tied up. A customer buys it in May using a credit card — the sale is recorded, the revenue counts, but the credit card company will not deposit the money until June. The supplier has been paid four months before the customer paid the retailer. That gap had to be funded by somebody. That somebody is the working capital of the business.

When the business is small or steady, the gap is manageable. When the business grows, the gap explodes. A retailer doing $1 million in sales might need $200,000 in working capital. The same retailer doubling to $2 million in sales might need $400,000 in working capital. Where does the extra $200,000 come from? It does not come from profit, which is fully consumed by the cost of growing. It does not come from revenue, which is still trapped in inventory and receivables. It comes from somewhere — investor capital, a line of credit, the owner's savings, supplier credit — or it does not come at all, and the business cannot fulfill the orders it already has.

This is why growth is dangerous. The faster a business grows, the more working capital it consumes, and the more vulnerable it becomes to running out of cash. The phrase growing yourself out of business is not a paradox. It is a precise description of a real and common outcome.

Three numbers, taken together, describe the working capital health of a business.

Days Sales Outstanding, or DSO, is the average number of days it takes to collect money from customers after a sale is made. A DSO of 45 means customers pay you on average 45 days after you invoice them. Lower is better. Lower DSO means the cash comes back to the business faster.

Days Inventory Outstanding, or DIO, is the average number of days inventory sits on shelves before being sold. A DIO of 60 means goods take two months from arrival to sale. Lower is better. Lower DIO means cash is tied up in inventory for less time.

Days Payable Outstanding, or DPO, is the average number of days the business takes to pay its own suppliers. A DPO of 30 means the business takes a month to pay its bills. Higher is better here — the longer you can ethically delay paying, the longer your suppliers are effectively financing your operations.

The three numbers combine into a single useful metric: the cash conversion cycle, calculated as DIO plus DSO minus DPO. It tells you how many days, on average, your cash is tied up in operations before it returns to you. A 95-day cash conversion cycle means that for every dollar of sales, you have to fund roughly 95 days of operating expenses before that dollar comes back. A 15-day cash conversion cycle is dramatically more capital-efficient. Some businesses — notably Amazon in its early years — have negative cash conversion cycles, meaning they collect from customers before they have to pay their suppliers. Negative cycles are a license to grow without consuming cash. They are very rare and very valuable.

The most useful frame is this: profit tells you whether the business is creating value. Working capital tells you whether the business can survive long enough to enjoy that value. The two numbers describe different problems and require different solutions. A business with strong profit and weak working capital management is in real danger. A business with weak profit but excellent working capital management can sometimes outlast a more profitable competitor that runs out of cash first.

Profit is the destination. Working capital is the fuel. Run out of either one and the journey is over.