Working Capital

A company that earns a profit and still runs dry needed an explanation. The income statement is clearly in the black while payroll day keeps turning into a scramble. Looking only at profit hides the cause, so the same surprise repeats every month.

The cause is usually where the money sits. Close a deal with a large customer and the revenue lands that month, but the payment arrives sixty days later. Salaries and server bills go out across those two months regardless. So closing more deals leaves less cash on hand. Double revenue and the unpaid balance doubles with it, which is how a growing company ends up borrowing because of its growth.

Working capital measures the amount tied up like that. It doesn't ask how much was earned but how much is currently inside the business in a form nobody can spend. Most of the gap between profit and cash is explained by this one line, which is why it gets read every month rather than every quarter.

Subtract the debts due within a year from the assets that turn into cash within a year. Filling in the two groups is the whole of the calculation.

1. The first group holds cash, accounts receivable, inventory, and prepaid costs. Receivables are amounts billed but not yet collected, and at a software company with no inventory they take up the largest position. A year of server fees paid up front and a rental deposit also belong here, since both are money already gone that comes back as service rather than as cash.
2. The second group holds unpaid bills, borrowings due within a year, and deferred revenue — money collected for service not yet delivered, which accounting treats as an obligation.
3. Subtract the second from the first. With $375,000 of cash, $450,000 of receivables, and $75,000 of prepaid costs, the first group is $900,000; with $225,000 of unpaid bills and $300,000 of deferred revenue, the second is $525,000, leaving working capital of $375,000.

A version that strips out cash gets used alongside it. Looking only at receivables minus unpaid bills shows whether the business structurally consumes cash or produces it. In the example, $450,000 less $225,000 leaves $225,000 structurally tied up.

Converting it into days is common too. If collection takes sixty days on average and paying suppliers takes thirty, the company is funding thirty days of its own costs. At $230,000 of monthly cost, that is $230,000 permanently locked inside the business. Let that spread widen and every increase in revenue increases the cash required with it.

There is no good or bad absolute amount. What to read is the direction and the ratio. Revenue up 30 percent with working capital up 30 percent means growth is consuming cash at the same rate; revenue rising while working capital stays flat means growth doesn't demand cash.

In a subscription business, negative working capital is the favorable sign. Annual payments collected up front accumulate as deferred revenue and enlarge the second group. Ten months of fees are already in the bank with only delivery remaining, so every new customer brings cash in ahead of the work. A company running on negative working capital is funding its growth from its customers, which is the cheapest financing available to it.

A rising share of enterprise customers tilts it the other way. Revenue from individuals paying by card arrives within days, while an enterprise contract means sending an invoice and waiting thirty to ninety days. The usual standard is to keep average days to collect inside thirty to forty-five, and to chase anything past ninety together with sales, since the person the customer will actually answer is usually the one who signed them.

It has to be read next to burn rate — the cash lost net each month. An increase in working capital never appears in profit but leaves the bank account in full, so burn rate catches it. That is also how a company that just reached profitability can feel cash pressure in its first profitable quarter. The practical response is to plan profit and cash separately, with the expected increase in working capital written into the cash plan in advance.

"Revenue is up and cash is down. Receivables are running two months late."

The gap between profit and cash comes from collection delay.

"Pushing annual billing up turns working capital negative and cash starts circulating."

A proposal to collect earlier and ease the pressure.

"This contract has ninety-day payment terms, so we're financing it for them."

The amount isn't the only thing to weigh when accepting terms.

At Pagedeck this number became a meeting topic in the quarter enterprise customers started growing as a share of revenue. Revenue beat the plan and cash came in under it. Grace opened the line items and found receivables had grown from $150,000 to $450,000, because most of the new enterprise customers were on sixty-day payment terms.

A rule came out of it. When payment terms run past sixty days, Sofia negotiates on the terms rather than on price, and customers who choose annual prepayment get a discount worth about two months. The company pulls its cash forward and the customer pays less.

The most common reading is that more working capital means a sturdier company. The word capital makes accumulation sound good. But the figure measures money locked inside the business and unavailable for anything else. A company whose working capital grew because receivables grew hasn't added assets; it has added money owed to it, and some share of that never arrives. The management goal is to shrink it to what's needed rather than to build it up. In practice that means aging what's owed into thirty, sixty, and ninety days and working the oldest bucket down.

The other belief is that this is a manufacturing or large-company concern. With no inventory, it sounds like a concept that doesn't apply to software. But payment cycles fill the space inventory used to occupy. Even card revenue takes a few days to settle through the gateway, and enterprise customers wait two months after an invoice. The larger revenue gets, the larger the amount suspended in between, so having no inventory is not a reason to skip this number. What changes for software is only which line carries the weight.