Working capital: why growing businesses often feel short of cash

Many owners notice something odd when the business starts growing: sales and profit are up, yet the bank balance is tighter than ever. This lesson explains why. For the basic definition and a simple example, read what is working capital? first. Here the focus is on how working capital moves as a business changes size.

What the number is

business.gov.au describes working capital as the cash available to a business for day-to-day expenses. It is usually measured from your balance sheet:

• Working capital = current assets - current liabilities

Current assets are cash or things you can convert into cash within 12 months, such as money in the bank, stock and money customers owe you. Current liabilities are amounts due for payment within 12 months, such as supplier bills, wages owed, tax owed and credit cards.

Two related measures help when you are thinking about growth:

• Current ratio = current assets / current liabilities. A figure of 1.5 means you hold $1.50 of current assets for every $1 of bills due within a year.
• Trade working capital = trade debtors + stock - trade creditors. This strips out cash and tax and shows only the money tied up in the trading cycle. It is the part that tends to grow with sales.

Why growth uses working capital

Three parts of the trading cycle usually grow in step with sales.

• Stock. Selling more usually means holding more stock, and you pay for it before you sell it. business.gov.au suggests making sure your stock levels are not too high, because stock on the shelf is cash you can’t use.
• Receivables. If customers take 45 days to pay, you always have about 45 days of sales waiting to be collected. Double the sales and you roughly double that balance.
• Supplier terms. Credit from suppliers works in your favour. The more you buy on terms, the more of your stock is funded by suppliers for a while. But supplier terms are usually shorter than the time stock and receivables take to turn into cash.

The gap between the two is the extra cash growth needs. It has to come from profit, from money the owner puts in, or from finance.

Worked example

Coastline Coffee Supplies is a fictional wholesaler in Geelong selling coffee beans and equipment to cafes. Its cost of goods sold is 60% of sales, and its trading pattern stays the same throughout:

• customers pay in about one and a half months (roughly 45 days)
• it holds about two months of stock
• it pays suppliers in about one month.

Monthly sales grow from $100,000 to $150,000.

Item	Before growth	After growth
Monthly sales	$100,000	$150,000
Monthly cost of goods sold (60%)	$60,000	$90,000
Trade debtors (1.5 months of sales)	$150,000	$225,000
Stock (2 months of cost of goods sold)	$120,000	$180,000
Trade creditors (1 month of cost of goods sold)	$60,000	$90,000
Trade working capital	$210,000	$315,000

Growth ties up an extra $105,000 ($315,000 - $210,000).

Now look at profit. The business makes a net profit before tax of about 8% of sales. Yearly sales rise from $1,200,000 to $1,800,000, so yearly profit rises from $96,000 to $144,000, an increase of $48,000.

Even if all of that extra profit arrived as cash in the first year, it would cover less than half of the $105,000 now tied up. The business is more profitable and still about $57,000 short of cash from the growth alone, before tax, owner drawings or loan repayments.

What if the owner got customers paying in one month instead of one and a half? At $150,000 of monthly sales, debtors would fall from $225,000 to $150,000, freeing $75,000. That one change covers most of the extra working capital the growth needs.

What changes in working capital may tell you

• Trade working capital rising faster than sales may mean customers are paying more slowly or stock is building up.
• Working capital falling while sales rise may mean the business is funding growth by stretching suppliers or running down cash.
• A falling current ratio means bills due within a year are growing faster than the assets available to pay them.
• Negative working capital means current liabilities are larger than current assets. Some businesses paid upfront can run this way, but for most small businesses it is a warning sign.
• Stock growing with no rise in sales may mean slow-moving or obsolete stock.

Where it appears in your financial information

• Balance sheet. Current assets and current liabilities are listed separately. business.gov.au notes a balance sheet helps you work out working capital. See the lesson on the balance sheet.
• Aged receivables and aged payables reports. These show how old your debtors and creditors are. See debtors and creditors.
• Stock reports. Your inventory system or accounting software can show stock on hand and how fast it moves.
• Cash flow forecast. Shows when growth will squeeze cash, month by month.

Planning for growth

Before you take on a big new customer or expand a product range, it may help to:

1. estimate how much extra stock and how many extra unpaid invoices the growth will create
2. compare that with the extra profit and cash the growth will bring in
3. build a month-by-month cash flow forecast for the next 12 months
4. look at what you control: invoice sooner, agree clear customer terms, order stock closer to when you need it and talk to suppliers about terms. business.gov.au also suggests working out how much margin you need from your sales to cover your costs.

For the method to turn these figures into a target amount, see how much working capital does my business need?

When to get professional help

A bookkeeper can make sure stock, debtors and creditors are recorded correctly, which the whole calculation depends on. An accountant can help you model growth scenarios, check whether your pricing and margins support the growth, and prepare a forecast. Talk to your accountant before committing to a large contract or expansion.

Where this becomes relevant to finance

When the gap between cash out and cash in is temporary and the business is profitable, some owners use finance to cover it. That is a decision to make after you have done what you can inside the business and understand your numbers. If the shortfall comes from losses rather than timing, read when borrowing is not the answer.

Important things to know

• Profitable growth can still run out of cash. Growth often uses cash before it produces it.
• Working capital is a snapshot. A healthy figure on 30 June says little about a big bill due on 15 July.
• Not all current assets are equal. Old invoices and slow-moving stock may never turn into cash at full value.
• Some cash belongs to others. GST, PAYG withholding and super you owe are not spare working capital.
• Growing slower can be a choice. Sometimes the safest option is to pace growth to what your cash can carry.