Working Capital

A company can be profitable on paper and still fail if it runs out of cash to pay this month's bills. Working capital measures that short-term cushion, and managing it well is one of the quiet arts of running a business. It builds directly on the current assets and current liabilities you learned to spot on the balance sheet, so this lesson turns that split into a practical health check.

The basic definition

Working capital equals current assets minus current liabilities. Because current items are the ones due within a year, working capital tells you whether a company's short-term resources can cover its short-term obligations. Positive working capital is a comfort buffer. Persistently negative working capital can signal liquidity stress, although, as you will see, not always.

The cash conversion cycle

Working capital is not static. It cycles. A company buys inventory, sells it, often on credit which creates receivables, and eventually collects the cash, while meanwhile delaying payment to its own suppliers. The cash conversion cycle measures how many days cash is tied up in that loop. The shorter it is, the faster cash comes back to the business.

• Days inventory outstanding (DIO): how long inventory sits before it is sold.
• Days sales outstanding (DSO): how long it takes to collect cash from customers after a sale.
• Days payable outstanding (DPO): how long the company takes to pay its own suppliers.
• Cash conversion cycle equals DIO plus DSO minus DPO: the net days cash is locked up in operations.

Working capital is the gap between when you pay your bills and when you get paid. The narrower and friendlier that gap, the stronger your cash position.

Why negative can be a superpower

Here is a point that catches a lot of people out. Some of the best businesses run negative working capital on purpose, because they collect cash from customers before they pay their suppliers. A retailer that sells goods for cash today but pays suppliers 60 days later is effectively funded by its own sales. For such a company, negative working capital is a sign of strength, not distress, which is exactly why context matters more than the raw number.

The link to cash flow

Changes in working capital flow straight into the cash flow statement, exactly as you saw in the reconciliation from profit to cash. When receivables or inventory rise, cash is consumed. When payables rise, cash is conserved. This is why a fast-growing company can be profitable yet cash-starved, because growth ties up ever more cash in inventory and receivables. You need to understand working capital to make sense of the operating section of the cash flow statement.

You can now judge a company's short-term health. Next we tackle a topic that quietly shapes both profit and cash, the spreading of asset costs over time through depreciation and amortization.