Working Capital

One term often referred to by investors and lenders is working capital. The financial projections template cash flow statement refers to changes in working capital as part of the cash flow from operating activities, but what is working capital, what does it mean, and how does it affect cash flow?

Working Capital Cycle

In a normal business, costs are incurred on purchases of inventory, wages, and other operating expenses in order to eventually create sales for the business. The money generated by the sales is then reinvested in the business to purchase more inventory, and incur more wages, and operating expenses, and the cycle repeats itself. Hopefully if we have done our sums correctly, the revenue exceeds the expenses and a profit is generated.

Cash Based Business

In an entirely cash based business, the cycle is one of cash flowing around the business without interruption. For example, suppose a business purchases a product costing 50, and immediately sells it for 120, making a profit of 70. The 50 flows out of the bank account to pay for the product, and 120 is immediately received from the sale. This is summarized in the diagram below. Expenses are also shown on the diagram but for simplicity are assumed to be nil in this example.

cash based business working capital

The cash flow from operating actives section of the cash flow statement would look like this.

Cash Flow in Cash Based Business
Profit 70
Cash flows from operating activities 70

In this simplified cash based business the cash and the profit are the same. The cash in the bank account is now 70 being the 120 received from the sale less the 50 paid for the product. The profit is also 70 resulting from the sales of 120 less the costs of 50.

Credit Based Business

However, very few businesses operate in this manner, in most businesses purchases of goods are made and expenses are incurred on credit and a balance of monies due to suppliers is built up, additional purchases are made resulting in an inventory of goods held in the warehouse, and finally, when a sale is made, goods are dispatched to the customer on credit resulting in a balance of monies owed by the customer.

In accounting terms the credit built up with suppliers is referred to as accounts payable, the goods held in the warehouse are referred to as inventory, and the monies owed by customers are called accounts receivable.

  • Amounts due from customers – Accounts receivable
  • Goods held for sale – Inventory
  • Amount due to suppliers – Accounts payable

These three items (accounts receivable, inventory, and accounts payable) are continually changing throughout an accounting period as purchases and expenses are incurred and sales are made and are referred to as working capital, and the flow around the system is referred to as the working capital cycle

Credit Based Business Example

As an example, suppose in our credit based business we purchase goods on credit costing 80, hold 30 as inventory, and sell the balance (50) on credit for 120, as shown in the diagram below.

working capital cycle 1.0

Again our profit is 70 which is the difference between the sales value (120) and the cost of the product sold (50), but what has happened to the cash?

No cash has flowed in or out of the business. We have purchased goods of 80 on credit and we now owe the supplier 80 (accounts payable). We have made a sale on credit of 120 and our customers now owe us 120 (accounts receivable). And finally, since we only sold goods worth 50, the remaining product of 30 is sitting in our warehouse as inventory.

If we reconcile where the profit from the sale has gone we get the following:

Cash gets used as Working Capital
Cash owed by customers (Accounts receivable) -120
Cash invested in inventory -30
Cash owed to suppliers (Accounts payable) 80
Net cash used in working capital -70

The cash from the sale has not yet flowed through to the business and has been used to increase the working capital of the business. The extract from the cash flow statement would now be shown as follows:

Cash flow with Working Capital
Profit 70
Accounts receivable -120
Inventory -30
Account payable 80
Net change in working capital -70
Cash flows from operating activities 0

The net cash flow into the business from operating activities is nil.

Net Change in Working Capital

In our simplified business, we assumed that the opening balances for accounts receivable, inventory, and accounts payable were zero. What affected the cash flow from one period to the next was the change in the working capital during the accounting period, summarized by the table below.

Change in Working Capital
Ending Opening Change
Accounts receivable 120 0 120
Inventory 30 0 30
Accounts payable 80 0 80
Working capital 70 0 70

This can be summarized in the change in working capital formula below.

Effect on cash flow = – Change in working capital

The minus sign is important as the effect on the cash flow is the exact opposite of the change in working capital.

Working Capital Equation

The working capital equation calculates the total working capital a business has at any point in time and can be stated as follows:

Working capital = Accounts receivable + Inventory – Accounts payable

For example, if at the start of an accounting period, the balance sheet shows accounts receivable of 70,000, inventory of 40,000 and accounts payable of 30,000, then the working capital is.

Working capital = Accounts receivable + Inventory - Accounts payable
Working capital = 70,000 + 40,000 - 30,000 = 80,000

Suppose the balance sheet at the end of the accounting period shows accounts receivable of 90,000, inventory of 55,000 and accounts payable of 35,000, then the working capital is.

Working capital = Accounts receivable + Inventory - Accounts payable
Working capital = 90,000 + 55,000 - 35,000 = 110,000

The working capital has increased over the accounting period by 30,000 as summarized in the table below.

Change in Working Capital
Ending Opening Change
Accounts receivable 90,000 70,000 20,000
Inventory 55,000 40,000 15,000
Accounts payable -35,000 -30,000 -5,000
Working capital 110,000 80,000 30,000

Assuming for example, the business has a net income of 70,000 for the period, then the extract from the cash flow statement would be as follows;

Cash flow with Working Capital
Net income 70,000
Accounts receivable -20,000
Inventory -15,000
Account payable 5,000
Net change in working capital -30,000
Cash flows from operating activities 40,000

The business has net income of 70,000, but the net increase in working capital of 30,000 reduces the operating cash flow to 40,000.

Notice that the effect on the cash flow shown in the cash flow statement (-30,000) is the opposite of the change in working capital (+30,000).

To summarize, the operating cash flow of a business is affected by the changes in working capital during the period. If the working capital increases then the cash flow decreases, likewise if it decreases, then the cash flow increases.

Overtrading Working Capital

Overtrading occurs when a business does not have sufficient finance for the level of working capital needed to support its level of trading. Overtrading often occurs with start up businesses as they have do not have the financial resources and access to capital that more established businesses have.

Typically, a startup business will seek to expand rapidly and in doing so will create the need for additional working capital. The faster the business grows the more working capital and therefore the more cash it needs.

The additional working capital requirement comes from two main sources.

  • Inventory will need to increase to satisfy customer demand as the business grows.
  • Amounts outstanding from customers (accounts receivable) will increase as sales increase.

Of course this increase will be offset by an increase in amounts due to suppliers (accounts payable), but unfortunately for a new business, credit offered by suppliers does not normally increase as rapidly as the requirement to give credit to customers.

This increase in working capital needs to be financed. Without additional funding to match the growth in the business, the cash balance will start to fall until the business cannot pay its suppliers. At this point the business will not be able to get the supplies of inventory necessary to satisfy customer demand, and the business will start to fail.

Overtrading Symptoms

By carefully monitoring the following items a business can spot the signs that may lead to overtrading:

  • Rapid sales growth
  • Declining gross profit margins as prices are cut to stimulate growth
  • Increasing inventory levels
  • Increasing accounts receivable (amounts due from customers)
  • Increasing accounts payable (amounts due to suppliers)
  • Decreasing cash balances

How to Correct the Overtrading

  • Reduce the amount of credit given to customers and speed up collections by cash settlement discounts in order to reduce accounts receivable.
  • Obtain additional credit from suppliers in order to increase accounts payable.
  • Reduce inventory levels.
  • Seek additional working capital finance facilities which increase as the business grows such as invoice finance, invoice discounting, or asset finance

Working Capital and the Financial Projections

All businesses need working capital, however, the level of and the changes in working capital during an accounting period directly impact the cash flowing in or out of the business and the amount of funding required from investors and lenders.

When producing a financial projection for a business plan, it is important to calculate working capital levels correctly. In the financial projections template this is achieved by changing the following three parameters.

  1. Accounts receivable – Days sales outstanding
  2. Inventory – Days inventory outstanding
  3. Accounts payable – Days payable outstanding

The diagrams used in this tutorial are available for download in PDF format by following the link below.

Last modified June 21st, 2019 by Michael Brown

About the Author

Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.

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