Managing Your Working Capital

If you’ve been reading the Haven blog for a while–or really, ever–then you know that we try to avoid using five-dollar words where a one-dollar word will do just fine. But we’re going to use one today, and today that money word is working capital.  It may sound like a theoretical term that only your accountant cares about, but it’s one that matters a lot to your business.  So let’s talk about what it is, why you should care, and how you should manage it.

Working capital is really just the difference between your current assets and your current liabilities.  Your current assets include things like cash and equivalents, accounts receivable, and inventory.  Your current liabilities include things like accounts payable.  We call it working capital because it is, quite literally, the rough amount of capital that you have to run your business on a daily basis; i.e., without taking out a large amount of financing or acquiring other assets.

Those three components of working capital are actually the basic components of the cash conversion cycle, which we’ve touched on briefly before.  The cash conversion cycle tells you how long it takes you, after you pay an invoice for inventory, to sell that inventory and collect on the resulting account receivable.  To get that number of days, we take days inventory, which tells you how many days on average inventory sits on your shelves before you sell it, add days receivable, which tells you how many days it takes you to collect receivables from your customers, and subtract days payable, which tells you how many days on average it takes you to pay off an account payable.

Working capital is a helpful measure because it gives us useful information about a couple aspects of your business.  For example, the more working capital you have on hand, the easier a time you’ll have paying your bills, which makes you less risky.  Great, you say, so I want to have as much working capital on hand as possible, right?  Wrong!  It’s nice to have less risk, but as with all things, it comes with a cost.  If you have a lot of cash in the bank, then sure, you’ll be less risky, but your cash isn’t going to earn you much of a return (and that’s before we factor in the bite that inflation will take out of it).  And if you have a lot of inventory on hand, then you have to finance it, which means carrying costs, and you have to worry about depreciation and losses from items that just don’t sell.  If you sit down to a meeting with your accountant or your fractional CFO, then be prepared for him to tell you that your business isn’t operating as efficiently as it could and that it’s starting to show in the return that you’re able to generate from your assets.

Now that we’ve got you wondering what the right level of working capital is, we’ll spoil it for you and tell you that there’s no right answer.  In general, you’d prefer to need less working capital and to have a shorter cash conversion cycle, but what constitutes a high or low level of working capital, or a long or a short cash conversion cycle, will vary depending on the nature of your business.

One helpful way to think about your working capital and cash conversion cycle is to break your cash conversion cycle down into days inventory, days receivable, and days payable and then ask yourself whether each metric is compatible with your business strategy and whether there’s a compelling business reason for any of those periods to be as long as they are.

For example, think back to our post on whether your business is a volume business or a margin business.  A volume business is trying to sell low-cost items with low margins, so in order to make any money, it needs to sell a whole lot of those items to earn its profit.  In contrast, a margin business is trying to sell very high-priced items that carry a very large margin, so it just isn’t going to be able to sell as many.  Buyers are going to take more time to make a thoughtful decision, so the business just isn’t going to be able to turn over its inventory as quickly.

So do you really need to have as much inventory on hand as you do?  Well, if you’re a volume business, then you might not want as much inventory on hand because you want to be able to sell it almost as soon as it hits the shelves.  But if you’re a margin business, then you may have to live with more inventory on hand because it needs to be there when the customer shows up, and they may be fewer and farther in between.

What about your accounts receivable?  Do your customers take forever to pay because there’s a legitimate reason for the delay?  Or do you just not get invoices out on time, just get them wrong, or just not follow up on payment when appropriate?  If you can find ways to nudge your customers to pay faster without rubbing them the wrong way, then you’ll get the cash in the door sooner.

And so it is with accounts payable, too.  If your suppliers give you thirty days to pay, then why would you ever pay sooner than that?  If your suppliers are offering you an interest-free loan, then take it.

So now back to our five-dollar word, working capital.  Whatever you call it, it’s something that you should always be thinking about in your business because it’s a roadmap for helping you think through the short-term trade-offs that you face.  Keep in mind the high-level metrics like working capital and the cash conversion cycle, break them down into their inventory, accounts receivable, and accounts payable components, and keep the relationships between them in mind as you make your operating decisions.