Working capital
The money trapped inside day-to-day operations. It is why a profitable company can run out of cash, and why some businesses are funded by their own customers.
Between making a sale and holding the cash, a business has money tied up in things it has bought but not yet sold, and in bills it has issued but not yet collected. That trapped money is working capital, and its movements explain most of the gap between profit and cash.
The three pieces
- Inventory — goods bought or made and not yet sold. Cash already spent, revenue not yet earned.
- Receivables — sales made on credit. Revenue already booked, cash not yet arrived.
- Payables — what the company owes suppliers. Costs already incurred, cash not yet paid.
The first two consume cash; the third supplies it. Working capital is roughly inventory plus receivables minus payables.
The cash conversion cycle
Inventory sits on the shelf for 60 days. Customers pay 45 days after invoicing. The company pays its own suppliers after 30 days. Cash conversion cycle = 60 + 45 − 30 = 75 days. The business must fund seventy-five days of operations out of its own pocket, every day, permanently.
Shortening that cycle releases cash without selling anything extra. Lengthening it consumes cash while the income statement looks unchanged.
Why growth eats cash
This is the part that surprises people. A growing company must buy inventory before it sells it and extend credit on every new sale. The faster it grows, the more capital is stuck in the pipeline.
A business growing 50% a year with a 75-day cash cycle needs continuous new funding simply to stand still operationally. If the funding stops — a lender withdraws, a share issue is postponed — the company can be both profitable and insolvent within a quarter. The accounts will look healthy until the moment they do not.
Negative working capital
Some businesses run the cycle in reverse: they collect from customers before paying suppliers. Supermarkets sell food within days and pay growers in weeks. Subscription software collects a year upfront and delivers monthly — see deferred revenue.
These businesses are funded by their own customers, at no interest. Growth generates cash rather than consuming it, which is a structural advantage that never appears as a line item anywhere.
Reading the movements
On the cash flow statement, the section between net income and operating cash flow shows changes in working capital. A large negative number means cash was absorbed; a large positive number means cash was released.
- Receivables growing faster than revenue can mean customers are paying more slowly — or that sales were pulled forward on generous terms.
- Inventory growing faster than revenue can mean demand disappointed, and a write-down is coming. See inventory accounting.
- Payables stretching sharply can mean the company is short of cash and leaning on suppliers.
- A single quarter of any of these is noise. A four-quarter trend is information.