Working capital: what it is, and why profitable businesses run out of cash

Found Funding · Guides

Working capital is the money tied up in the day-to-day running of your business — stock on the shelves, work you have done but not yet invoiced, invoices issued but not yet paid — less what you owe suppliers in the same period. It is not profit and it is not the bank balance. It is the gap between spending money to do the work and getting paid for having done it.

Understanding that gap is the single most useful piece of financial literacy for a small business owner, because it explains the thing that otherwise makes no sense: how a profitable, growing business runs out of money.

Growth consumes cash before it produces any

Consider a business that wins a contract twice the size of its usual work. It buys materials up front. It pays wages while the job runs. It delivers, invoices, and then waits out the customer's payment terms — thirty days if it is lucky, sixty or ninety if it is not.

Every one of those steps costs money before any arrives. The bigger the contract, the bigger the outlay and the longer the wait. Win two such contracts at once and the business can be more profitable than it has ever been and unable to pay its own wage bill in the same month. Nothing has gone wrong; the business has simply grown faster than its cash cycle can support.

Measuring your own gap

You can put a number on it, and it is worth doing. Work out roughly how many days pass between paying your suppliers and being paid by your customers. Multiply that by your average daily cost of sales. That is approximately the cash permanently locked inside your trading.

Two things follow. First, that money does not come back while you continue trading at the same level — it is not a temporary shortfall, it is a structural requirement. Second, it grows in proportion to turnover. Double the business and you roughly double the working capital it needs. Owners who plan for the profit of growth and not the cash cost of it are the ones who get caught.

The levers you control before you borrow anything

Invoice faster. Not chase faster — issue faster. Days between completing work and sending the invoice are days added to the cycle at no benefit to anyone. For many businesses this is the single largest and cheapest improvement available, and it requires no finance at all.

Set terms deliberately and enforce them. Payment terms are a commercial decision, not a convention. If your customers pay in sixty days and your suppliers want thirty, you are financing your customers' businesses out of your own. Sometimes that is a price worth paying for the relationship. It should at least be a decision.

Look at stock. Stock is cash in a different shape. Slow-moving lines are working capital sitting on a shelf, and reducing them releases money without borrowing it.

Negotiate upstream. Longer supplier terms shorten the gap just as effectively as faster customer payment, and are often easier to achieve.

When finance is the right answer

When the gap is structural rather than sloppy. If you have shortened the cycle everywhere you reasonably can and the business still needs more cash to operate at the level it is trading at, that is a funding requirement rather than a discipline problem — and funding it is a normal, unremarkable thing for a business to do.

The facilities differ in shape, and matching the shape matters more than the rate:

• Overdraft — simple, flexible, and usually repayable on demand. Convenient, but the limit can be reduced at the moment you most need it.
• Revolving credit facility — behaves like an overdraft but is normally committed for a term. That certainty is generally worth paying for.
• Invoice finance — advances against unpaid invoices, so the facility grows with sales instead of sitting at a fixed limit. Suits a business whose need rises with turnover.
• Trade finance — funds the purchase rather than the receivable. Suits importers and anyone paying suppliers before they can sell.
• Merchant cash advance — repaid as a share of card takings, so it flexes down in a quiet month. Useful in retail and hospitality, and usually expensive.

Arrange it before you need it

Working capital finance is easiest to obtain when the figures look calm and hardest when the need is urgent, which is unfortunately the reverse of when people go looking for it. A facility arranged during a steady quarter, sitting undrawn until a large order arrives, costs very little and removes the scenario where you turn down work you could have delivered.

That is the practical case for treating working capital as something you plan rather than something you react to: the cheapest version of this facility is the one you set up before anything is wrong.