Working Capital is the competitive advantage you don’t know about. Here’s why…

Working capital is one of the financial terms that confuses most people. It is often misunderstood for cash. Which it is not. It sounds like it an asset. Which it is. But not all assets are working capital. So, what is working capital and what are some of its best practices?

Here’s some quick information about working capital to give you some foundation:

1. Working capital is a verb, not a noun.
2. Working capital is a business cycle.
3. Working capital is measured in days.

When running a business, there’s a timing difference between when you pay for things and when you get paid. The time that elapses between paying for raw materials (paying your web designer to create your website), selling your finished product (the services/products on your website) and collecting cash (your sales) is known as working capital.

Now, the technical definition:

Working capital = Current Assets — Current Liabilities

Again, working capital is the amount of time required by your business operations to convert current assets and current liabilities into cash. In laymen’s terms, it’s a measure of how fast you can collect on the sales you made on credit and how quickly you can turn the inventory sitting on warehouse shelves into cash. Here’s an example:

Example — The Home Version

Margaret is an independent graphic designer who gets paid by her client every six weeks. Rent on Margaret’s “home office” is due every four weeks. Since Margaret gets paid two weeks after rent is due, she borrows money from her family each month to pay her rent.

Question 1: What is wrong with Margaret’s situation?

Answer: Margaret gets paid two weeks after her rent is due, and borrows money to stay afloat.

Question 2: How can Margaret fix this situation?

Answer: Ask to be paid the 3rd week of every month.

Moving forward, let’s see how working capital works on a larger scale.

Three balance sheet accounts are the primary drivers of any company’s working capital:

1. Accounts receivable (A/R) — aka, the sales you’ve made on credit.
2. Inventory
3. Accounts payable (A/P) — aka, the purchases you’ve made on credit.

Let’s say you have 45 days of sales in accounts receivable but you only extend 30 day credit terms to your customers. This means you’ve been slow to collect. By shaving off 10 days on your days outstanding, you can put $10,000 in your bank account without increasing sales or cutting costs by a dollar. Note: this examples assumes $1,000 in average daily sales.

Money tied up in working capital is money that’s not available to fund growth initiatives.

Notice that A/R is part of this calculation. A/R is a current asset and it reflects the sales you’ve made on credit. You’ll collect the cash later, usually in 30 days. If you own part or all of your office building (meaning it’s not fully mortgaged), the building is also an asset–but unless you’re willing to sell your building or borrow against it, then it’s not working capital. It’s an “other asset”.

So, why is it important to understand working capital?

At some point, you will have to transition from self-funding or funding by investor to funding by customer. The working capital cycle of your business can either gobble up more than its fair share of cash or it can be managed as an efficient cash flow system when funding by customer.

Entrepreneurs, you should manage your balance sheet as tightly as you manage your income statement. Working capital is a good first step in managing your balance sheet. If done correctly, working capital can become one of your company’s most significant competitive advantages.

Originally published at facingthenumbers.com on April 6, 2016.