Working Capital
Working capital is the cash tied up in day-to-day operations: inventory plus trade receivables minus trade payables. It shows how much liquidity growth consumes before it turns into cash received.
What the figure measures
Time passes between the moment a company pays for materials or work and the moment its customer pays. During that time money is tied up. That is what working capital measures.
The operating formula is inventory + trade receivables − trade payables. The balance-sheet version sets total current assets against current liabilities; for steering the business the operating version is more useful, because it contains only what the business itself creates.
Why growth consumes cash
A company that doubles revenue generally doubles receivables and inventory too. At working capital of 20 percent of revenue, an increase of five million euros ties up another million – money that has to be found before the cash comes in.
This is why profitable companies can run into a liquidity crisis. Profit and cash are not the same thing, and in most cases the difference is called working capital.
The three levers
- Receivables. Payment terms, dunning, deposits, progress invoices on long projects. The fastest lever, because it needs no investment.
- Inventory. Cover per item, slow movers, safety stock. Slower to work, but durable.
- Payables. Supplier terms – with the caveat that early-payment discount is often worth more than the cash benefit: three percent for 30 days' difference is an annualised rate of roughly 36 percent.
What negative working capital means
If the figure is negative, the business finances itself: the customer pays before the supplier has to be paid. Typical for subscription models billed in advance, for retail with high stock turnover and for platforms. That is an advantage – but one that turns into a burden when revenue falls, because cash then flows out rather than in.
Role in a company sale
Purchase agreements normally fix a normal level of working capital; if the actual balance at completion is below it the price falls, above it the price rises. The basis is a monthly series over at least twelve, better 24 months. Building that series only during the process means negotiating over a number you cannot evidence – see quality of earnings.