Working capital

Why a profitable business runs short of money

Trading consumes cash before it produces it. Stock has to be bought before it is sold. Work has to be done before it is invoiced. Invoices have to be issued before they are paid. Every one of those steps ties money up, and the faster a business grows the more money it ties up, which is why expansion and cash shortage so often arrive together.

This is the ordinary explanation for the most common confusion in small-business finance: the accounts report a profit and the bank account disagrees. Both are correct. The profit has been earned and is currently sitting in stock and in amounts owed rather than in the bank.

Reading the cycle

Working capital is best understood as a cycle with a length. Money leaves when stock is bought, sits while it is held, sits again while a customer takes time to pay, and returns when payment arrives. Time owed to suppliers works in the opposite direction and shortens the cycle. A business with a long cycle needs more funding to support the same level of trade than one with a short cycle.

That is why the three practical levers are always the same: hold less stock, be paid sooner, and pay later where terms allow. Each shortens the gap between money leaving and money returning, and each has a cost elsewhere, which is what makes the balance a genuine management decision rather than an arithmetic one.

Short-term position, illustrative round numbers

  Cash                                        20
  Stock held                                  55
  Owed by customers                           70
                                          ------
  Short-term assets                          145
  Owed to suppliers and others               -90
                                          ------
  Working capital                             55

Illustration only. The figures demonstrate the calculation and describe no actual business.