Working Capital: What It Is, How It Moves and What It Says

Working capital is the money tied up in running a business day to day: what customers owe it, plus what sits in stock, less what it owes suppliers. Working capital rises as sales rise. More sales mean more owed by customers and more stock held, so a growing business often needs cash for working capital even while it is profitable. Its size and direction say how the business is run.

Between the day a business pays for its materials and the day its customer pays for the finished goods, the money is out of the account and not yet back. Working capital is how much is out at any moment. Money that is out is not available for anything else: not for a new machine, not for a loan instalment, not for the person who runs the place. Money out of the account is the whole subject. The figure is built from three lines of a balance sheetThe statement listing what a business holds and what it owes on one date, as against the profit statement, which covers a stretch of time.; each line pushes it one way, a growth year enlarges it, and its size and its direction say how a business is run.

What is working capital, in plain words?

Start on a street, not in a spreadsheet. A cloth shop takes delivery of Rs 2,00,000 of fabric from a wholesaler who lets the shop pay in a month. For that month the shop is trading on the wholesaler's money and has nothing of its own at stake. Then the month ends, the wholesaler is paid, and the fabric is still sitting on the shelf. Now it is the shop's own Rs 2,00,000 lying there in the form of cloth. A tailor buys a bolt of it and asks for two weeks to pay. The cloth has gone, the money has not arrived, and the shop is still Rs 2,00,000 down. Only when the tailor pays does the money come home.

Working capital is the money a business has pushed out into stock and into unpaid customer bills and has not yet got back, less whatever its own suppliers have not yet made it pay. Notice that the shopkeeper never made a bad decision anywhere in that sequence. Buying stock is the job. Giving the tailor two weeks is how business is done on that street. Nothing went wrong, and yet money sat outside the till for weeks. Working capital is therefore not a problem to be solved so much as a permanent feature to be sized, funded and watched. Every trading business has one, and its size is set by the trade it is in.

What are its three parts, and which way does each push?

Three lines of the balance sheet do all the work. ReceivablesMoney customers have been billed for and have not yet paid. Receivables sit on the balance sheet as something the business is owed, not as cash. are the bills the business has raised and not yet collected: goods gone, money promised. InventoryEverything held for the trade: raw materials, goods part finished, and finished goods waiting to be sold. Valued at what it cost, not at what it will sell for. is everything held for the trade, from raw material to finished goods on the loading bay. PayablesMoney the business has been billed for by its suppliers and has not yet paid. Payables are a debt, and until they are paid the supplier is lending the business the goods. are the bills suppliers have raised on the business and it has not yet paid.

Receivables and inventory push working capital up because they are the business's money sitting somewhere other than the bank, and payables push it down because they are somebody else's money doing the business's work. The signs follow from that and from nothing else. If a customer pays sooner, less is owed to the business, and the figure falls. If stock turns over faster, less is held, and the figure falls. If a supplier agrees to wait longer, more of the operation is financed by the supplier, and the figure falls again. The last one is worth saying plainly. A rising payables balance reduces working capital, and on paper the fall looks like an improvement. The same fall can equally mean the business has quietly stopped paying people on time.

Sohan Ply and Boards Private Limited, an invented maker of plywood and laminates running one plant, sells Rs 1,80,00,00,000 of board a year. Its three lines read: receivables Rs 30,00,00,000, inventory Rs 27,00,00,000, payables Rs 21,00,00,000. Add the first two and subtract the third and the working capital is Rs 36,00,00,000.

How much of a year's sales sits inside the machine?

A rupee figure on its own says very little. Rs 36,00,00,000 is a great deal for a corner store and a rounding difference for a refinery, so the figure only becomes readable when it is set against the size of the trade it supports. Sohan Ply sells Rs 1,80,00,00,000 a year and carries Rs 36,00,00,000 of working capital, exactly one fifth of a year's sales. Say it the way an owner would: for every Rs 5 of board that leaves the plant, Rs 1 is parked inside the business and stays parked for as long as the business keeps trading at that level.

A share of sales is the right way to read working capital. The share is the price of admission to the trade the business is in, and it barely moves unless the way the business trades changes. A plywood maker holds timber, holds boards part made, holds finished stock in several sizes and sells to dealers on credit, so a fifth of sales tied up is unremarkable for that trade. A vegetable stall holds stock for hours and is paid in coins, so its share is near zero. A shipbuilder may tie up several years of sales. None of these is better managed than the others; they are different trades. The comparison worth making is between a business and the way it traded last year, or between two businesses doing the same thing.

Why does working capital move with sales?

Watch what a busier month actually does. Sohan Ply wins a second dealer in a nearby town and starts shipping twice a week instead of once. A dealer must never wait, so shipping twice a week means holding more finished board, more timber upstream and more part-made board on the line. The new dealer buys on the same credit terms as everybody else, so at any moment there is a larger pile of unpaid bills. The supplier bills more too, so payables rise as well, but suppliers cover only part of the picture. The net position moves up.

Each of the three parts is a stock of goods or of bills, and each scales with how much the business is buying, holding and selling, so working capital moves roughly in proportion to sales. That proportionality is an assumption, not a law, and it is worth knowing what could break it: a business can buy in bulk once a year and hold stock that does not scale, or take advances that hold receivables down, or hit a limit at which suppliers refuse to extend more credit. But as a first approximation over a year or two of ordinary growth, the proportional reading is the right one to start with, and every practitioner uses it before checking whether it held.

Why can growth eat cash while profit is rising?

Owners are surprised by this part more than any other, and the arithmetic is worth doing row by row. Sohan Ply plans a 20 per cent growth year. Sales go from Rs 1,80,00,00,000 to Rs 2,16,00,00,000. Receivables go from Rs 30,00,00,000 to Rs 36,00,00,000, inventory from Rs 27,00,00,000 to Rs 32,40,00,000, payables from Rs 21,00,00,000 to Rs 25,20,00,000. Working capital lands at Rs 43,20,00,000, up Rs 7,20,00,000. The extra Rs 7,20,00,000 has to be paid out during the year, to timber merchants and to the wage bill, before a single extra rupee arrives from a dealer.

The last two rows are the point. Put them beside each other. The growth year adds Rs 4,20,00,000 of operating profit before depreciationWhat the trading operation earns after its running costs but before charging the wearing out of machines, before interest and before tax. A rough stand in for the cash the operation throws off., since a fifth more sales at the same margin earns a fifth more. The same growth year absorbs Rs 7,20,00,000 into working capital. Growth is the one activity that reliably produces a profit and a cash shortfall at the same time, and here the shortfall is Rs 3,00,00,000 in the year the business grows fastest. The reason is arithmetic rather than bad luck: working capital at Rs 36,00,00,000 is larger than a year's operating profit of Rs 21,00,00,000, so a given percentage increase in sales pulls more into the balance sheet than it pushes onto the profit line. Divide Rs 7,20,00,000 by Rs 4,20,00,000 and the extra profit takes about twenty one months to earn back the extra working capital, assuming the higher sales hold.

Two things soften that reading and both are worth knowing. The working capital step is paid once at the new level. The extra profit repeats every year the business stays there. A business that grows and then holds steady gets its cash back through the second and third years. And a business that stops growing sees the flow reverse: sales flat means no further absorption, and sales falling actually releases cash as stock is run down and old bills are collected. A shrinking business can therefore look cash rich for a year or two while its underlying trade is deteriorating, and cash generated in a bad year should always be checked against what happened to these three lines.

What does a business's working capital reveal about it?

Now the reading. Here the figure earns its keep. Three things are worth looking at, and none of them is the rupee number on its own. The first is the level against sales. A level names the trade the business is in and how much cash that trade demands before anything else happens. The second is the direction against sales: if sales grew 20 per cent and working capital grew 20 per cent, the machine is running as it did; if working capital grew 40 per cent, something inside changed and the analyst needs to know which part. The third is the mix. One total can be reached by very different routes.

Each of the three parts names a different thing going on inside the business, so the useful signal is never the working capital total but which part is moving faster than sales. Receivables outrunning sales says collection has slipped, or a large buyer has started paying late, or goods were pushed onto dealers near the year end to make the sales figure. Inventory outrunning sales says goods are not moving, or a deliberate build up ahead of a season, or that obsolete stock is sitting at cost on the balance sheet because nobody has written it down. Payables outrunning sales says suppliers are being stretched. Stretching a supplier may be negotiating strength or a cash squeeze in disguise. To tell the two apart, ask the suppliers, or watch whether the business is paying late on things it never used to.

The fourth shape on that panel runs the other way. Some businesses collect before they pay. A busy sweet shop takes cash across the counter every evening and settles with its milk and flour suppliers weeks later. A wedding caterer takes a customer advanceMoney a customer pays before the goods are delivered or the work is done. Until the business delivers, the money is a liability, not income. before the first vegetable is bought. For those businesses working capital is negative: the customers and the suppliers between them fund the whole operation, and growth releases cash instead of eating it. Negative working capital is not a sign of virtue and not a sign of distress on its own; it is a description of the trading pattern, and it makes those businesses much cheaper to grow than a plywood maker who has to fund a fifth of every rupee of sales.

How do a lender, an analyst and an investor actually read it?

Three readers pick up the same three lines and want different things from them. The bank is usually the one funding the gap. Start there. Sohan Ply has a working capital lineA revolving borrowing limit a bank sets for day to day trading, drawn and repaid as cash comes and goes, as against a term loan repaid on a fixed schedule. of Rs 15,00,00,000 secured on inventory and receivables. A lender does not lend against the whole of those balances, but applies a haircutThe percentage a lender knocks off the stated value of security before deciding how much to lend against it, allowing for the chance that the security fetches less than its book value. to each. Unsold board fetches less in a forced sale than its book value, and some dealer bills will not be collected at all. So the bank reads working capital as the thing it is financing and as the pool it is secured against at the same time, and it watches the mix closely: receivables from a spread of dealers are better security than one large unpaid bill, and finished board is better security than a shed of part-made panels.

A lender funds working capital and takes security over it, an analyst subtracts the change in it to get from profit to cash, and an investor prices what future growth will cost in cash before agreeing what the business is worth. For Ritu Chandran, the finance head at Sohan Ply, the practical version of the lender's view is simple: the Rs 7,20,00,000 that the growth year needs has to be arranged before the year starts, from the Rs 4,00,00,000 of cash on hand and the headroom on the line, and arranging it in March is a different conversation from arranging it in October when the timber is already bought.

The analyst's use is narrower and mechanical. Profit is measured when a sale is made; cash arrives when the customer pays. The bridge between them is the change in working capital over the period, subtracted when it rises and added when it falls, and that single adjustment explains most of the distance between a profit figure and the cash a business actually generated.

The investor's use is the one that decides prices. Deodar Growth Partners, an invented private equity investor looking at 20 per cent of Sohan Ply, is not buying this year's profit; it is buying several years of it. If the plan is to grow at 20 per cent a year, then every one of those years absorbs cash into working capital before it returns any, and the investor will want to know whether that is funded by the bank, by the business holding back what it pays out, or by the investor writing another cheque later. A growth plan presented with a profit forecast and no working capital line beneath it gets sent back.

Sohan Ply and Boards Private Limited, Sohan Malhotra, Ritu Chandran and Deodar Growth Partners are invented.
Educational material. Not advice on any investment, tax, budget or market position.