Working capital

Chapter 6 asked why profit and cash diverge. This is usually the answer.

What it is

Between buying materials and being paid for the finished product, a company's money sits in things rather than in the bank. That is working capital, and it has three parts.

Inventory. Goods bought or made and not yet sold.

Trade receivables. Goods sold and not yet paid for.

Trade payables. Goods bought and not yet paid for — which works the other way, funding the company for free.

working capital ≈ inventory + receivables − payables

Every rupee of it is cash the business has produced and cannot use.

The three day-counts

Converted into days, these become comparable and far more legible than rupees.

inventory days   = inventory ÷ cost of goods sold × 365
receivable days  = receivables ÷ revenue × 365
payable days     = payables ÷ cost of goods sold × 365

Cash conversion cycle = inventory days + receivable days − payable days.

That is the number of days between paying for something and being paid for it. A cycle of 70 days means the business funds itself for ten weeks on every sale.

Some businesses run a negative cycle — they collect before they pay. Supermarkets and some platform businesses do this, and it is a genuinely powerful position: growth generates cash instead of consuming it.

Why growth eats cash

The thing that surprises people, and it explains most of the gap between a good income statement and a bad bank balance.

A company growing 40% with a 70-day cycle needs 40% more working capital. That money has to come from somewhere: retained profit, borrowing, or new shares.

So a fast-growing profitable company can be perpetually short of cash, and nothing is wrong. It is funding its own expansion through the gap between selling and collecting. Chapter 6's pattern — positive operating cash, very negative investing, positive financing — is exactly this.

The judgement is whether the growth is worth the cash it absorbs, which is chapter 9's question: are the returns above the cost of the capital being consumed?

Where deterioration shows first

Working capital is an early warning system, because it moves before the income statement does.

Rising receivable days is the one to watch hardest. It means customers are taking longer to pay. Three explanations, in ascending order of concern: a mix shift towards customers with longer terms; looser credit extended to win sales; or customers who cannot pay.

The third eventually becomes a write-off, and the write-off hits profit a year or two after the days started climbing. By then the receivables line had been saying so for some time.

Rising inventory days means goods are not moving. Could be a build-up ahead of demand, and could be product nobody wants. Inventory that is not selling eventually gets written down.

Rising payable days is ambiguous and worth care. It may be negotiating strength — a powerful buyer dictating terms. It may be a company that cannot pay its suppliers. Read it alongside cash: stretching payables while cash falls is stress, not strength.

The check that catches the most

Compare the growth in receivables with the growth in revenue.

If revenue grew 20% and receivables grew 20%, the business scaled. If revenue grew 20% and receivables grew 60%, something changed in how sales are being made or collected — and that gap is visible a year or more before anything appears in profit.

The same comparison for inventory against cost of goods sold.

This single check, done over five years, finds more problems than any ratio in this subject.

Reading it fairly

Seasonality. A year-end figure may be a seasonal low. Compare the same date across years, and use the half-yearly balance sheet of chapter 5 where the pattern looks arranged.

Industry norms differ enormously. Long-cycle engineering carries months of working capital; a restaurant carries almost none. Compare with peers, not across industries.

Factoring and supply chain finance. Receivables sold to a financier leave the balance sheet, which flatters receivable days without the underlying collection improving. The notes disclose it.

The point

Working capital is cash trapped between paying suppliers and collecting from customers, measured as inventory days plus receivable days less payable days. Growth consumes it, which is why profitable fast-growing companies run short of cash. Receivables growing faster than revenue is the earliest reliable warning in the accounts.