When running out of cash is a (Working) Capital Offence
Working Capital is often talked about, but what is it, really? And what does it have to do with a company’s cash needs?
The best place to start is the balance sheet. This humble staple of accountants works on the simple formula that what you’re worth equals what you have, minus what you owe. For example, if your only asset is a $300,000 flat with an outstanding $200,000 mortgage, then your net worth is $100,000, being the value of the flat less the mortgage. What I call “worth” is called equity in business, so:
· Equity = Assets — Liabilities, more commonly shown as
· Assets = Liabilities + Equity.
This is why balance sheets always balance.
Assets can either be current, meaning they are expected to become cash soon, like inventory, customer accounts receivable and cash itself, or fixed, such as equipment and buildings, that cannot readily be converted into cash.
Liabilities consist of bank overdrafts, unpaid taxes, supplier invoices and the like.
Equity consists of the original investments by shareholders plus accumulated profits less any distributions such as dividends. It’s best to include long-term loans in equity, as they form part of the company’s source of funding.
So here’s a simplified balance sheet:
The text book definition of Working Capital is:
· Current Assets — Current Liabilities, which is the same as
· Equity — Fixed Assets
The latter definition is the better one to use. The size of a company’s Fixed Assets is generally pretty stable, so for Working Capital to increase, equity needs to increase. That means that Working Capital increases in line with profits.
We can simplify the balance sheet further:
Once the Fixed Assets have been acquired, the rest of the investment is Working Capital. So when a VC describes its investment into a tech company for the purposes of “increasing working capital”, it just says they are not planning to invest in new plant and equipment, acquire licenses or make investments in other companies, but rather to have funds available for more inventory, accounts receivable and so on.
Working Capital becomes much more interesting when you remove cash:
· Working Capital = Net Working Capital + Cash
Leaving our balance sheet looking like this:
NWC comprises the various items around a company’s trading: Accounts Receivable and Payable, Inventory, Work in Progress, Deferred Revenue etc. These are all proportionate to sales: if sales double, accounts receivable would double, for example. If sales halve, receivables would halve.
So NWC rises and falls in line with sales growth and WC rises and falls with profits and losses, with cash as the balancing item.
When profits are generated at least as fast as sales growth is increasing the NWC, cash flow is positive. When the company is growing faster than that, cash is consumed, which is why fast growing companies consume cash and mature companies generate cash.
Companies therefore have a sustainable growth rate that can be calculated. And that, my friends, is an awesomely powerful metric that every company should be aware of and track.
