Working capital, and why running out of it closes shops

Working capital is current assets minus current liabilities. Current assets are the things expected to turn into cash within about a year: the bank balance, cash in hand, money customers owe you, stock, and prepayments. Current liabilities are what you must settle in the same period: supplier balances, staff dues, taxes payable, the portion of a loan falling due within the year, and customer advances against goods not yet delivered.

Subtract one from the other and you have a rough measure of whether the business can meet its near-term obligations out of its near-term resources. Positive working capital means there is more coming available than falling due. Negative means the opposite, and while that is survivable for businesses that collect cash before they pay for stock, it is a precarious position for most.

What the definition obscures is that this is not a measure of money. It is a measure of resources at different distances from being money, added together as though they were equivalent. Two hundred thousand rupees of working capital consisting entirely of a bank balance and two hundred thousand consisting entirely of slow-moving stock are the same figure describing two completely different situations. That gap between the arithmetic and the reality is where most of the practical trouble lives.

A business can be profitable every month and run out of working capital, and the sequence by which it happens is ordinary rather than exotic.

Sales grow. Because sales are on credit, each additional sale adds to receivables rather than to the bank. To supply the higher volume, more stock is bought, and stock is generally paid for sooner than customers pay you. So growth consumes cash: the gap between paying for goods and being paid for them has to be funded, and it widens with volume. Profit is being earned on every transaction and simultaneously being converted into stock on shelves and amounts owed by other people.

This is why growing businesses fail, which sounds paradoxical and is not. The technical description is that the cash conversion cycle is longer than the payment terms the business can obtain, and every rupee of extra sales makes the funding requirement bigger. A business that is flat is at least not increasing its need.

The distinction to hold onto is between being unprofitable and being illiquid. Unprofitable means the model does not work and needs changing. Illiquid means the model works and there is not enough money in the right place at the right time. They demand different responses, and mistaking the second for the first leads to cutting the wrong things.

Working capital is mostly not money. It is money held in two forms that resist being spent.

Stock is the first. Every item on the shelf is cash converted into an object, and it returns to being cash only when it is sold and paid for. Stock that moves quickly is close to money. Stock that has sat for two years is money that is very far away and getting further, since its realisable value is falling, and it also carries storage, insurance and obsolescence costs. The important asymmetry is that stock appears at cost in the accounts regardless of whether it will ever sell at that price, so a balance sheet can carry a comfortable stock figure that overstates the cash it will produce.

Receivables are the second. Money owed by customers counts in full whether it is a week old or a year old, and whether the customer is solvent or not, until somebody decides to write it down. An ageing analysis, which splits receivables by how overdue they are, is the standard way of seeing past the total, and it is worth doing precisely because the total conceals the shape.

On the other side, supplier credit is the cheapest working capital there is, since it funds your operations at no interest for the length of the terms. Using it fully is sensible; exceeding it silently is borrowing without asking.

Working capital pressure builds over months and the profit-and-loss statement is the last place it shows. Three indicators are visible earlier and can be calculated from records you already have.

The first is the collection period lengthening. Divide receivables by sales for the period and multiply by the number of days to get the average days it takes to collect. Track it monthly. A number drifting upward means cash is arriving later, and the drift is usually gradual enough that nobody notices it in individual transactions.

The second is stock holding rising relative to sales. The same calculation with stock and cost of goods sold gives roughly how many days of stock you hold. Rising means more cash is going into inventory than the sales rate justifies, whether because of over-ordering or because part of the stock has stopped selling.

The third is your own payment behaviour. Paying suppliers progressively later, using the informal tolerance a long relationship allows, is the earliest and most reliable indicator, and it is one nobody writes down. If you are now settling at the end of the month what you used to settle on receipt, that is the measurement.

Watch them as trends rather than levels. There is no universal correct value for any of them, because a jeweller and a vegetable seller are not comparable, but a business is comparable to itself last quarter.

Every route to more working capital takes it from somewhere, and the cost is often paid by a relationship rather than in interest.

Collect faster. Tighter follow-up, deposits on large orders, or a discount for early settlement. The discount is real money given away, and it is worth comparing against what short-term borrowing would have cost before assuming it is the cheaper option.

Hold less stock. Order smaller quantities more often, and clear slow-moving lines even at a loss, because stock that will not sell at cost is not worth what the books say. The cost is a higher risk of being out of stock and losing the sale, and losing bulk discounts.

Pay later. Negotiating longer terms openly is legitimate and works when the supplier values the volume. Simply paying late is different: it transfers your problem to the supplier, and where the supplier is a micro or small enterprise there is a statutory framework around delayed payments whose application depends on classification and the specific facts, so it is worth asking a professional rather than assuming it does not apply to you.

Bring money in. Owner funds, a working capital facility such as an overdraft or cash credit line, or invoice financing. These solve a timing problem with a timing instrument, which is the right match, and they cost interest and usually security. What none of them fixes is a business whose margins do not cover its costs, and using a facility to fund losses converts a profitability problem into a debt problem.

Working capital is a figure derived entirely from your own records, which means it inherits every judgement inside them and cannot see anything outside them.

It cannot tell you whether the receivables are collectible. A customer who will never pay contributes to positive working capital at full face value until somebody makes the decision to write the amount off, and no ratio detects that. It cannot tell you whether the stock is saleable, for the same reason: cost is recorded, realisable value is estimated, and the estimate is made by people with an interest in it being high. It cannot tell you what is committed but unrecorded, such as an order placed verbally or a repair that is about to be needed.

Most importantly the figure is a snapshot at a date, and working capital pressure is about timing within a period. A business with healthy working capital on the last day of the month can be unable to pay on the fifteenth, because the obligations and the inflows do not arrive in a convenient order. The tool for that is not a ratio at all; it is a forward list of expected receipts and payments by date, built from what is known and what has been promised.

Which is the honest boundary. Any system can compute this ratio from the ledger, flag the trend and show the ageing. Whether a specific customer will pay, whether a stock line is dead, and what has been promised in a conversation are inputs a human has to supply, and the number is only as good as they are.