The Working Capital Trap

Given that accrual accounting creates a disconnect between profit and cash, we need to know the place for that missing cash. It is generally trapped in something called Working Capital. Let's find out how to unlock it.

In the case where a company is very profitable but has no cash, the money is usually tied up in the day-to-day operations of the business. Thus, this is Working Capital. The capital necessary to facilitate the ongoing operations of a business is working capital.

There is a simple formula for Working Capital:

\[ \text{Working Capital} = \text{Current Assets} - \text{Current Liabilities} \]

Before we look at where the cash hides, let's quickly define those two terms:

• Current Assets: This is your actual cash; plus, anything you expect to turn into cash within the next 12 months (like your inventory or money owed by customers).
• Current Liabilities: Current liabilities are your short-term bills and debts that are payable by you in the next 12 months (like supplier invoices, short-term bank loans).

To manage this, non-finance managers must keep an eye on three large "cash traps.":

1. Accounts Receivable (Waiting for Customers)
2. Inventory (Cash on Shelves)
3. Accounts Payable (The Good Trap)

Accounts Receivable (Waiting for Customers)

Offering a product on credit may yield you a profit on the Income Statement, but nothing in cash. Your money is fundamentally stuck in your customer's bank account until they pay you. If your customers take 90 days to pay, you will have cash flow issues regardless of how profitable you are.

Inventory (Cash on Shelves)

Suppose you purchased $50,000 worth of shoes to resell in your store. The sum of $50,000 is immediately removed from your bank account. But until you sell those shoes, that cash is frozen as rubber and leather on your shelf. Excessive inventory hinders cash flow.

Accounts Payable (The Good Trap)

You owe this money to your suppliers. If you purchase materials today but your supplier permits you to pay them within 60 days, you are able to retain your cash within the bank for an additional two months! It is wise to delay payments without damaging relationships to protect cash flow.

In order to survive, managers must quickly collect cash from customers, keep inventory low, and pay suppliers slowly.

Working capital is what links a profitable idea with a surviving business. Offering customers the option to stall payment while your warehouse fills up with unsold goods will leave you without cash. We should ascertain your ability to calculate working capital!