Between selling something and being paid for it, a business funds the gap out of its own pocket. Working capital is the size of that gap, and it is why growing companies run out of money.
11 min read · Level 3
Working capital is treated as a technical subject and it is really a commercial one wearing technical clothes. Every day added to the collection period is a customer relationship, a contract term, or an invoicing process that somebody could change; every day of stock is a decision about how much certainty of supply is worth. Framed as a financing gap, the answer is always to borrow more, and borrowing is genuinely the right answer sometimes. Framed as a set of choices about how the business trades, the answer is frequently that a modest operational change releases a large amount of permanent cash at no interest cost. The reason the financing framing wins so often is not that it is better; it is that it can be executed by one person in an afternoon, and the operational one requires persuading customers, which is harder and nobody enjoys it.
Working capital is what a business has tied up in the ordinary business of trading: money owed by customers, plus stock it has bought and not yet sold, minus money it owes suppliers and has not yet paid. Excluding cash and borrowings from the calculation gives the operating version, which is the one that actually behaves like a use of money.
It matters because it scales. A business that ties up twenty cents of working capital for every dollar of annual revenue needs another twenty cents every time revenue grows by a dollar - and that money has to come from somewhere before the profit on the additional sales arrives.
The timing can also be expressed in days: how long customers take to pay, how long stock sits before it sells, and how long the business takes to pay its own suppliers. Combined, those give the cash conversion cycle - the number of days between money going out and money coming back.
Because it is the single most common reason a profitable small business fails. Growth does not announce itself as a funding requirement; it announces itself as good news. The funding requirement arrives silently, as a receivables balance that keeps rising, and it has to be met every month whether or not anyone has noticed it exists.
And because deterioration in working capital is often the earliest visible sign that something is wrong commercially. Customers pay more slowly when they are struggling or when they are unhappy. Stock builds up when it is not selling. Both show in the working capital numbers well before they show anywhere else.
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Northgate Tools, operating working capital - receivables plus inventory minus payables:
End Year 1: 560,000 plus 610,000 minus 480,000, which is 690,000 End Year 2: 790,000 plus 800,000 minus 600,000, which is 990,000
The increase is 300,000, and that is exactly the sum of the three working capital lines in the cash flow statement: 230,000 plus 190,000 minus 120,000.
Now the useful decomposition. As a share of revenue, working capital was 690,000 over 3,500,000, or 19.71%, and is now 990,000 over 4,200,000, or 23.57%.
If the intensity had stayed at Year 1's 19.71%, the 700,000 of additional revenue would have absorbed 0.1971 times 700,000, which is 138,000. The actual absorption was 300,000. So 138,000 is the price of growing and 162,000 is the price of working capital becoming more intensive - and those are two entirely different problems with two entirely different remedies.
In days:
Days customers take to pay: 560,000 over 3,500,000 times 365 is 58.4 days in Year 1; 790,000 over 4,200,000 times 365 is 68.7 days in Year 2. Days stock is held: 610,000 over 2,100,000 times 365 is 106.0 days; 800,000 over 2,520,000 times 365 is 115.9 days. Days taken to pay suppliers: 480,000 over 2,100,000 times 365 is 83.4 days; 600,000 over 2,520,000 times 365 is 86.9 days.
Cash conversion cycle: 58.4 plus 106.0 minus 83.4 is 81.0 days in Year 1; 68.7 plus 115.9 minus 86.9 is 97.7 days in Year 2.
Almost seventeen more days of funding required, on a larger revenue base. And the forward arithmetic is the part worth sitting with: at Year 2 intensity, another 1,000,000 of revenue would absorb about 236,000 of cash - more than the 225,000 the business generated from operations in the whole of Year 2.
Growing faster would make Northgate less solvent, not more.
The first mistake is including cash and borrowings in the calculation. The textbook definition of working capital - current assets minus current liabilities - mixes the trading cycle with the bank balance, and the resulting number moves for reasons that have nothing to do with trading. Northgate's total working capital barely changed at all, from 1,010,000 to 1,035,000, which conceals the entire story.
The second is watching the absolute figure rather than the intensity. Working capital should rise as a business grows; the question is whether it is rising faster than revenue, and only the ratio answers that.
The third is assuming a longer payment period from suppliers is free money. It is, until it is not: the terms can be withdrawn, and they are usually withdrawn at the first sign of difficulty.
The fourth is treating working capital as a finance problem to be funded rather than an operational one to be fixed. Ten days off the collection period releases real cash permanently, costs nothing in interest, and requires somebody to make phone calls.
Receivables plus inventory minus payables. Do it for at least two years. This is the figure that behaves like a use of money, and it is not the one the standard current-assets-minus-current-liabilities formula gives you.
The ratio is the intensity of the business. A rising ratio means each additional dollar of revenue now costs more to fund than it used to, which is a change in the business rather than a consequence of growth.
Multiply the prior year's intensity by the increase in revenue - that is what growth alone would have absorbed. Whatever the actual increase exceeds it by is deterioration. The two halves have completely different remedies.
Receivables over revenue times 365; inventory and payables over cost of goods sold times 365. Days are comparable across years and across companies of different sizes, which raw balances are not.
Multiply the intensity by the revenue increase you expect. Compare that with the cash the business actually generates. If the first is larger than the second, growth has to be funded externally or slowed, and that is better discovered now than in nine months.
Whenever a business is growing, whenever profit and operating cash flow have diverged, and as an early warning system on any company whose customers or stock you can observe over time.
Do not apply this framework to businesses that collect before they deliver. Subscription and prepayment models frequently run negative working capital, where growth releases cash rather than consuming it, and the diagnosis reverses entirely.
A shape that appears repeatedly in accounts of small-business failure is a company that wins a substantially larger contract or customer than it has handled before, delivers it successfully, and runs out of money doing so. The mechanism is arithmetic rather than mismanagement: materials and labour are paid for weeks or months before the customer pays, so a larger order enlarges the gap in proportion. The business is more profitable and less solvent at the same time, and the two facts are produced by the same event.
The cash requirement of an order arrives before the profit on it does. Whether a business can afford to win is a separate question from whether the work is worth doing.
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