Working Capital

Don’t forget it when doing financial modeling

I have seen many financial models, both from a consulting and also from an investor/deal-flow analysis. And for me the number one omission is the proper treatment of working capital, especially the negative one.

Some models just ignore the fact that working capital exist. All revenues on the income statement generate a bottom line that is directly used in a cash flow statement. A few capital expenditure, debt or dividend adjustments and that’s it. Dead wrong. I sincerely doubt that any business, especially start-ups, can have zero-impact working capital.

Other models attempt to reflect working capital by providing a gross estimation adjustment on the payables and receivables, as if they were all the same. While it is better than nothing, it is an over-simplification. Payables are not all the same. Salaries and office rental have to be paid on time. Some suppliers are willing to get paid later (especially if your company is bigger than them) than others. On most countries, turnover taxes and sales taxes have to be paid 15-30 days after the billing date, whereas you might collect your revenues in a period much longer than that. The same goes for receivables. It might be the case that selling something directly or through intermediaries (i.e. agencies, sales agents) can impact heavily on collection days. Or selling product A on a specific country can generate a short-term cash need due to longer collection days than other countries. Doing a proper working capital analysis, especially on the receivables side, can help the management to decide where to grow the company and how much capital they need for that, besides what they need to start-up the project or for capital expenditures.

When modeling working capital on a spreadsheet, my suggestion is to enable an assumption I usually call “lag factor”, which is basically a time shift (days, months, quarters or years… whatever unit you are using) that will enable every revenue and cost line to move properly. That way the cash flow statement will accurately reflect when money actually is cashed in or out.