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.

A worked example: sizing the gap

Illustrative example. Take a business turning over £600,000 a year, with cost of sales — materials, subcontractors, direct labour — running at £360,000. It buys on 30-day supplier terms but its customers, mostly larger firms with their own procurement processes, pay in 60 days. It also carries around three weeks of stock at any one time.

Add the stock and debtor days together (21 + 60 = 81) and subtract the 30 days of supplier credit, and the business is financing its own trading for roughly 51 days out of every year. Daily cost of sales here is £360,000 ÷ 365 ≈ £986, so that is about £986 × 51 ≈ £50,000 of cash permanently tied up in the business before a single pound of profit is available to spend. That figure does not go away while the business keeps trading at the same level — it is a structural requirement, not a one-off shortfall — and it grows if turnover grows.

Measuring your own gap

You can put the same kind of number on your own business. Work out roughly how many days pass between paying your suppliers and being paid by your customers, including any stock sitting unsold in between. Multiply that by your average daily cost of sales, as above. 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 than they look — a supplier who wants to keep the account will frequently agree if you ask directly rather than simply paying late.

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 chasing the cheapest headline cost:

• 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; the invoice finance calculator gives a rough sense of what might be released against a sales ledger.
• 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; see the merchant cash advance calculator for how the repayment tracks takings.

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. The working capital finance page sets out the full range of facilities in one place if you want to compare them side by side.

Common questions

Is working capital finance the same as an overdraft?

No, though an overdraft is one form it can take. Working capital finance is a broad category covering any facility used to fund the day-to-day cash gap between paying costs and being paid by customers, and it includes overdrafts, revolving credit facilities, invoice finance, trade finance and merchant cash advances. An overdraft is one specific product within that category: a flexible, usually on-demand facility attached to a current account. The other forms behave differently — invoice finance and merchant cash advances, for example, grow or shrink with sales rather than sitting at a fixed limit — so the right choice depends on how your particular cash gap behaves, not just its size.

How much working capital finance can a business get?

It depends on the facility and the numbers behind it rather than a fixed multiple of turnover. Invoice finance is typically sized against the value of an unpaid sales ledger, a merchant cash advance against recent card takings, and an overdraft or loan against turnover, trading history and existing commitments. Two businesses with identical turnover can be offered very different amounts, because a lender is assessing the strength and reliability of the cash flow behind the number rather than the number alone. The only reliable way to see what a specific business might be offered is to put the actual figures in front of lenders rather than estimate from a rule of thumb.

Will applying affect my credit score?

An initial search to see what might be available does not need to involve a hard credit check, and comparing options at that stage should not touch your credit file. A formal application to a specific lender is a different step: at that point the lender will usually want to see your accounts and may carry out a credit search as part of underwriting the facility properly. It is worth treating the two stages separately — comparing what is realistically on offer first, then applying formally only once you have picked the facility that actually fits your cash gap, rather than making several formal applications in parallel.

How quickly can working capital finance be arranged?

It varies widely by product. Invoice finance and merchant cash advances can often be arranged within days once paperwork is in order, because they are underwritten largely against sales data that is quick to verify. A bank overdraft, revolving credit facility or term loan usually takes longer, often several weeks, because the lender is assessing the business as a whole rather than a single data feed. If a lender has already declined an application, it is worth understanding what that decline actually means before applying elsewhere — the guide on being declined for a business loan covers what to check and what to do next. Either way, arranging a facility ahead of need removes the time pressure that makes a slow process feel risky.