Working capital and the cost of growth

What working capital actually is

Working capital is the money committed to running the business day to day, as opposed to the money spent on buildings, vehicles and equipment. In practice it is a short calculation: trade receivables plus inventory less trade payables. That figure is cash that belongs to the business but is not available to it, because it is sitting in a warehouse or in a customer accounts payable queue.

People often quote the accounting definition, current assets less current liabilities, which is fine for a balance sheet but unhelpful for management, because it mixes in the bank balance, the overdraft and the tax accrual. Those items obscure the thing you are trying to manage. Operating working capital, the three trading items only, is the number that tells you how much cash your trading model requires, and it is the number that moves when you change how you sell, stock and buy.

Expressed as a percentage of revenue it becomes a planning tool. If working capital is consistently 24 percent of revenue, then every additional 1,000,000 of revenue will require roughly 240,000 of cash before it produces anything. That single ratio, tracked over a couple of years, will tell you more about whether you can afford your growth plan than any forecast built from scratch.

Three levers and nothing else

There are exactly three levers. You can collect faster, hold less stock, or pay later. Every working capital initiative that has ever been run is one of those three, or a combination. It is worth being blunt about that, because it stops the discussion becoming abstract and turns it into a small number of specific operational changes with owners and dates attached.

Each lever has a limit that is not financial. Push receivables too hard and you lose customers to a competitor with easier terms. Cut inventory too far and you lose sales to stockouts, and in some trades a stockout costs you the customer, not just the order. Stretch payables past what was agreed and you lose priority in allocation, lose settlement discounts, and eventually lose the supplier. Working capital management is finding the point on each lever where the cash released stops being worth what it costs elsewhere.

• Receivables: how long between delivering and being paid. Controlled by terms, invoicing speed, dispute resolution and collection discipline.
• Inventory: how long goods sit before being sold. Controlled by range, reorder policy, forecasting and how ruthlessly slow lines are cleared.
• Payables: how long between receiving goods and paying for them. Controlled by negotiated terms, and by paying on the terms you agreed rather than earlier or later.

A baseline, illustrative, in Canadian dollars

Take an invented distributor to make the numbers concrete. Annual revenue is 6,000,000 CAD at a 30 percent gross margin, so gross profit is 1,800,000 CAD and cost of sales is 4,200,000 CAD. Net margin after overheads is 6 percent, which is 360,000 CAD of net profit. On the balance sheet it holds trade receivables of 855,000 CAD, inventory of 1,035,000 CAD and trade payables of 460,000 CAD.

So this business has 1,430,000 CAD permanently committed, against 6,000,000 CAD of revenue: 23.8 percent of revenue. It earns 360,000 CAD a year. Put those two figures side by side and something important becomes visible. The business earns, in a full year, about a quarter of what it already has tied up in stock and unpaid invoices. Any change of scale is going to be dominated by the working capital number, not by the profit number.

• DSO: 855,000 divided by 6,000,000, times 365, equals 52.0 days.
• DIO: 1,035,000 divided by 4,200,000, times 365, equals 89.9 days, which we will round to 90.
• DPO: 460,000 divided by 4,200,000, times 365, equals 40.0 days.
• Cash conversion cycle: 52.0 plus 89.9 minus 40.0, equals 101.9 days, or about 102 days.
• Operating working capital: 855,000 plus 1,035,000 less 460,000, equals 1,430,000 CAD.

What happens when revenue doubles

Suppose the business doubles revenue to 12,000,000 CAD over two years, and nothing about how it operates changes. Margins hold, terms hold, stock cover holds. Receivables become 1,710,000 CAD, inventory becomes 2,070,000 CAD, payables become 920,000 CAD, and operating working capital becomes 2,860,000 CAD. The increase is 1,430,000 CAD.

Where does 1,430,000 CAD come from? Profit over those two years, if it grows in line with revenue, might total somewhere in the region of 1,100,000 to 1,250,000 CAD before tax, owner drawings and any capital spending. After those it is not enough, and it arrives after the cash is needed rather than before. The stock has to be on the shelf before the sale, and the invoice is unpaid for 52 days after it. So a doubling of revenue in this business demands roughly 1,400,000 CAD of funding that trading itself will not supply in time.

This is the calculation that is missing from most growth plans. The plan says revenue doubles and profit doubles, which may well be true, and stops there. The question it does not answer is: what is the peak cash requirement between here and there, in which month does it occur, and where is that money coming from? A growth plan should always carry a working capital line, and that line should be built by applying the current ratios to the forecast revenue, which takes about ten minutes.

Note also that this is the benign version, in which nothing deteriorates. In reality rapid growth usually brings new customers who are less well vetted and pay more slowly, wider stock ranges bought to win those customers, and pressure on suppliers who have not yet extended terms to match the higher volume. Each of those makes the ratios worse at exactly the moment volume is making the base bigger.

Overtrading

Overtrading is the name for growing faster than your working capital can support. It is not a failure of demand or of pricing. It is a business taking on more volume than it can fund, and the symptoms are consistent enough to be recognisable.

The dangerous feature of overtrading is that every instinct points the wrong way. The business is winning work, so the natural response is to win more, take on more staff, and buy more stock, all of which deepen the hole. The correct response is usually to slow down deliberately: to be selective about which orders to take, to insist on better terms or deposits on the larger ones, and to spend a quarter fixing the cycle before growing again. That is a hard decision to take while the phone is ringing, which is why it is so often taken too late.

Overtrading also has a distinctive endgame. It is rarely a slow decline; it is an abrupt stop, triggered by a single event, usually a large customer paying late or failing, or a supplier moving the business to cash on delivery. The underlying condition existed for months, but nothing forced it into the open until one node in the chain moved.

• The order book and revenue are both growing, and everyone in the business is busy.
• Reported profit is positive, sometimes at record levels.
• The overdraft or facility is drawn deeper each month and never fully clears.
• Suppliers are being paid later than agreed, and the conversations with them have started to change tone.
• Payments are prioritised weekly by who is shouting loudest rather than by what is due.
• Stock is being bought for specific urgent orders at short notice, usually at worse prices.
• Tax or payroll liabilities are being carried into the following period.

Receivables: credit control is a growth constraint

Credit control is usually treated as an administrative chore delegated to whoever has time. In a business with a long cycle it is closer to a core function, because it directly determines how much growth the business can fund. Every day of DSO in the illustrative business is 6,000,000 divided by 365, which is 16,438 CAD. Twelve days of improvement releases about 197,000 CAD at the current scale, and about 394,000 CAD at the doubled scale.

The work divides into three parts, and most businesses only do the third. Before the sale: decide who gets credit, how much, and on what terms, based on something more than optimism. During the transaction: invoice on the day of delivery, with the customer purchase order number and everything else the customer needs to pay it, because an invoice that cannot be matched will sit in a queue until someone chases it. After: chase systematically, by value, starting before the due date rather than after it.

One number is worth keeping in mind during any decision about extending credit. At a 30 percent gross margin, a 30,000 CAD bad debt destroys the gross profit on 100,000 CAD of sales. Writing off one bad customer requires replacing them and then finding another 100,000 CAD of revenue just to be back where you started. Credit granted is not a sales decision; it is a lending decision made without a lending licence.

• Set a credit limit for every customer and enforce it in the system, so exceeding it requires a decision rather than being noticed later.
• Invoice on the day of delivery. Days between delivery and invoicing are added to your cycle for nothing.
• Confirm the invoice reached the right person in the right format before it becomes overdue, particularly with large corporate customers.
• Work the ageing report by value. The largest ten balances usually account for most of the money at risk.
• Close disputes within a week. An unresolved query about a price or a delivery quietly becomes an unpaid invoice, then bad debt.
• Escalate on a fixed schedule that everyone knows, rather than when someone remembers.
• Consider deposits or stage payments for large or bespoke orders. This is far easier to agree before the order than after.

Inventory: the quietest place to lose money

Inventory is the lever owners are most reluctant to pull, because holding stock feels like being ready for customers and cutting it feels like risking sales. Both instincts are correct at the margin and wrong in aggregate, because stock is almost never spread evenly. In most ranges a minority of lines produce most of the sales and a long tail produces very little while consuming a disproportionate share of the cash.

The practical approach is to stop treating inventory as one number. Classify it: fast-moving lines where availability wins business and stockouts are expensive; medium lines with predictable demand; slow lines held for service reasons; and dead stock that has not moved in a year and is not going to. The right policy is different for each. High cover on the first group is a legitimate investment. High cover on the fourth is a loss that has already happened and has not yet been recognised.

In the illustrative business, one day of inventory is 4,200,000 divided by 365, which is 11,507 CAD. Taking stock cover from 90 days to 70 days releases about 230,000 CAD at current scale, and about 460,000 CAD after doubling. That is the single largest lever available to this business, and it is entirely internal: it requires no negotiation with any customer or supplier.

Two disciplines make it real. First, count regularly enough that the stock figure in the accounts is true, because inventory decisions taken on wrong data are worse than no decisions. Second, put a date on clearing dead stock, and accept the loss on it. Stock written down or sold cheaply hurts once; stock held indefinitely costs cash, space and management attention every month, and usually ends up being written off anyway at a worse price.

Payables: the lever with the shortest rope

Supplier credit is the cheapest funding available to most small businesses, and it is usually free. Extending DPO releases cash immediately and costs nothing on the face of it. That is why it is also the lever most easily abused, and the one where the damage takes longest to become visible.

There is a firm distinction between negotiating terms and simply paying late. Negotiated terms are an agreement: your supplier prices for it, plans around it and continues to treat you as a good customer. Late payment is a unilateral decision that transfers your cash problem to someone else. In the short run they look identical on your balance sheet. Over a year they diverge sharply, because the late payer loses allocation priority when stock is short, loses access to settlement discounts, gets quoted worse prices at renewal, and is the first to be moved to payment in advance when the supplier has its own cash problem.

Settlement discounts deserve arithmetic rather than instinct. A discount of 2 percent for paying in 10 days instead of 60 days means giving up 50 days of credit to save 2 percent. On an annualised basis that is roughly 2 divided by 98, times 365 divided by 50, which is about 14.9 percent a year. If your cost of borrowing is below that, taking the discount is worthwhile; if you are financing the payment on an expensive facility, it may not be. Either way it is a calculation, not a preference.

Fix the cycle, or finance it

When a growth plan shows a working capital gap, there are two responses, and the order matters. Fixing the cycle releases cash permanently and costs nothing in interest, but it takes months and has operational limits. Financing is fast and reliable but costs money every year and does nothing about the underlying requirement. Almost always the right answer is to do as much of the first as is genuinely achievable, then finance the remainder deliberately rather than accidentally.

Return to the illustrative business facing a 1,430,000 CAD increase from doubling revenue. Suppose it improves DSO from 52 to 40 days, DIO from 90 to 70 days, and DPO from 40 to 50 days, all at the doubled scale. Twelve days of DSO at 32,877 CAD a day is 394,500 CAD. Twenty days of DIO at 23,014 CAD a day is 460,300 CAD. Ten days of DPO at 23,014 CAD a day is 230,100 CAD. Together that releases about 1,085,000 CAD, which covers roughly three quarters of the increase and leaves a much smaller and more fundable gap of around 345,000 CAD.

Those improvements are demanding but not fantastical, and the point of the calculation is not to promise the outcome. It is to show that the operational levers are of the same order of magnitude as the financing requirement, which is the reason to attempt them first. A business that finances a broken cycle carries the cost of that cycle forever, and the cost grows with the business.

When financing is the right answer

Some cycles cannot be shortened much. A business selling to large corporate customers or to government will not negotiate 30-day terms; a manufacturer with a long production cycle cannot compress it; an importer with 45 days at sea has a fixed component in its DIO that no amount of discipline will remove. In those cases the working capital requirement is structural, and it should be funded with a facility that matches its shape.

Two rules apply regardless of instrument. Match the term to the need: funding a permanent working capital requirement with a facility repayable on demand puts the survival of the business in someone else's hands. And arrange it early. Facilities are cheaper, larger and less restrictive when granted to a business with a clean record and a forecast, than to one in visible difficulty three weeks from a payroll run.

It is also worth knowing what financing costs in the language of the business. A facility at 9 percent on 1,000,000 CAD is 90,000 CAD a year. At a 6 percent net margin, that is the profit on 1,500,000 CAD of revenue, a quarter of the current turnover, spent on carrying the cycle. Framed that way, the case for shortening the cycle usually makes itself.

• A revolving facility or overdraft sized against the receivables and inventory it supports, not against an arbitrary comfort level.
• Invoice finance or receivables discounting, which converts the receivable to cash early at a cost, and which is priced against your customers' credit quality as well as your own.
• Trade or import finance for the goods-in-transit portion of the cycle, where the funding follows the specific shipment.
• Equipment finance or leasing so that capital purchases do not consume the working capital line.
• Equity, where the requirement is permanent, large and tied to a step change rather than a seasonal swing.

Growing at a rate the business can fund

There is a growth rate that a business can sustain from its own profits without new funding and without changing its ratios. Conceptually it is straightforward: if working capital is 24 percent of revenue and retained profit is 6 percent of revenue, then each extra 100 of revenue demands 24 of cash, while the existing revenue base throws off 6 for every 100 it turns over. Dividing 6 by 24 gives 25 percent, so a business in this shape can add roughly 25 percent to its revenue in a year from its own retained profit before it needs either funding or a shorter cycle.

You do not need a formula to use this idea. The useful version is a habit: before committing to a growth target, apply the current working capital percentage to the extra revenue, compare the result to the profit you expect to retain over the same period, and look at the timing of both. If the requirement exceeds the retained profit, growth needs either funding or a shorter cycle, and it is far better to know that in advance than in month seven.

This also reframes what a good customer is. A customer who pays in 30 days at a 25 percent margin can be worth considerably more than one who pays in 120 days at a 32 percent margin, because the second is consuming cash that would otherwise fund four times as much trade. Once the sales team understands what a day of DSO is worth, terms stop being a giveaway in a negotiation and become part of the price.

The monthly review

Working capital rewards routine over analysis. A short monthly review, always the same, always compared to the previous month, catches drift while it is still small. The review needs five things: DSO, DIO and DPO for the month; operating working capital in currency and as a percentage of revenue; the ageing report with the over-90 bucket visible; the slow-moving and dead stock position; and the largest single movement in any of them since last month, with an explanation.

Two habits make the review effective. Set targets for each of the three ratios and hold someone accountable for each, because a ratio nobody owns does not improve. And translate every change into cash: a two-day rise in DSO is not a statistic, it is a specific amount of money that left the business this month, and stating it that way changes how people react to it.

The data should come from one place. Where sales, purchasing and stock sit in the same ledger, the ageing, the stock valuation and the cycle can be produced from the records themselves rather than assembled by hand in a spreadsheet each month; Skyline Nexus produces the receivables and payables ageing and the inventory position from the same underlying data, which mainly matters because it removes the argument about whose numbers are right and leaves the conversation on what to do about them.