The Importance of Working Capital in Cash Flow Management

A recent Yale School of Management paper by AJ Wasserstein, who researches entrepreneurship and small businesses, details why working capital is too often an overlooked element of cash flow management

Managing working capital can feel like a chore, in large part because of the sheer number of variables that affect it. There is no quick fix that unilaterally increases access to working capital or smooths the ups and downs of a business’ cash flow. Yet in the worst case, failing to devote active and dedicated attention to working capital can make businesses falter, or even fail entirely — and no matter what, it can result in businesses leaving money on the table that could otherwise create value for owners and employees.

Yale School of Management professor A.J. Wasserstein and his colleagues acknowledge as much in a recent paper titled, “On the nature of working capital: Understanding its mysteries and complexities.” The authors write, “While this topic is wonky and lacks the glamour of strategy, it can be a huge driver of business success.”

“In any business (but especially small ones), working capital can make or break the organization’s financial health,” the paper reads, yet “few young, first-time, and inexperienced entrepreneurs (and even seasoned operators) seem to truly internalize the influence and importance of working capital on free cash flows in a business.” Few operators are more seasoned than Michael Dell, founder and CEO of Dell Technologies, whom the authors quote at the outset of their paper as saying: “We were always focused on our profit and loss statement. But cash flow was not a regularly discussed topic. It was as if we were driving along, watching only the speedometer, when in fact we were running out of gas.”

In this post, we’ll unpack the Yale paper to spotlight how its learnings can be applied to small and mid-sized businesses, which tend to lack adequate, reliable access to working capital.

What exactly is working capital, and how does it function?

Working capital is the liquidity a business taps into to run its operations. It’s calculated by subtracting current liabilities from current assets — but since each of those is composed of many other calculations with variables that change day to day, it can be exceedingly difficult for a business to know it’s exact position. Accounts payable fall into the current liabilities bucket, and accounts receivable fall into the current assets bucket. The timing of payments can have real impact on the accessibility of working capital, as well as cash flow.

Wasserstein is the Eugene F. Williams, Jr. lecturer in the practice of management. His Yale bio, which includes links to a number of other papers, notes that “his research, writing, and teaching concentrate on search funds, entrepreneurship, programmatic acquisitions and small businesses,” and that “he is a private investor with a long-term orientation, interested in lower middle-market businesses and philanthropic organizations.” In the paper he notes, “working capital is like health: Ignore it at your own peril, because when it flags it will be the only thing you think about.”

He defines working capital in straightforward terms: “the money a company needs to finance its daily operations,” noting that a variety of activities “fall under the banner of ‘daily operations,’ including inventory purchasing, extending payment terms to customers, and prepaying expenses.”

Access to working capital allows businesses to meet their financial obligations — like making payroll — but keeping too much cash on hand limits opportunities for investment. Shortening the cash conversion cycle and eliminating cash flow gaps increases a business access to working capital, as does strategic use of cost-effective credit. All require knowledge of and the ability to control a variety of financial levers in a business. Wasserstein speaks to such complexities, saying, “Less working capital and a shorter CCC [cash conversion cycle] are beneficial to the business. This might be counterintuitive to some when we have been ingrained to believe that owing people money is bad. However, when you owe people money, less capital is invested and tied up in your business.”

Why it's important

In addition to keeping a business stable by ensuring it can pay its bills, working capital helps businesses grow. Access to sufficient liquidity not only helps companies weather unexpected storms or seasonal ups and downs, it also allows leaders to seize opportunities when they arise.

“A business with lower working capital requires less investment to grow. For many businesses, growth in revenue requires significant investment. Normally, we think about this in terms of capital expenditures, such as on vehicles or equipment. But often, growth also requires an investment in working capital. More revenue creates more AR, inventory, and payroll, which require more cash to fund,” Wasserstein writes. In businesses where customers pay upfront before a product is produced or a service rendered, the cash conversion cycle is so short that risks to working capital can be controlled easily — but such an approach can be impractical for many businesses. Even so, Amazon, for example, has managed the rare feat of achieving a negative cash conversion cycle of -48 days. As Marketplace Pulse put it: “That is, on average the company took in cash from customers 24 days before it paid it out to suppliers.”

On the flipside, it can be much more expensive to run a business without reliable access to working capital. Seeking a loan under duress causes leaders to accept less favorable terms.

How to improve your own working capital

As noted above, minimizing cash flow gap and boosting cash conversion cycle can significantly improve working capital, as can having a credit solution in your back pocket.

“There are no silver bullets in the realm of small business working capital management. No single action will cut your business’s working capital balance by half in one fell swoop. Instead of seeking home runs,operators must pursue singles. A focus on the numerous small things that affect working capital, along with a consistent dedication to instilling healthy cash management processes in your employees, will produce results,” Wasserstein writes. In other words, improving accounts payables and receivables processes, regular forecasting of cash flows and tracking of key performance indicators like DSO’s and DPO’s are things that all businesses — and particularly small and mid-sized businesses — should have visibility into and control over.

“Effective working capital management requires constant dedication. We analogize it to weeding the garden. Stop weeding, and your progress will quickly recede. An individual with significant clout must lead the charge, as individual contributors have conflicting incentives. If the operations team manages raw material purchasing, inventory will bloom. If the sales team manages AR, customers are likely to receive overly favorable payment terms. Someone with a bird’s eye view of the entire financial position of the business must be responsible for decisions related to working capital. In a small business, this person is often the CEO. Many CEOs sign every check; we approve of this practice. While time-consuming, the exercise is an effective way to keep a watchful eye on the company’s cash position,” Wasserstein writes.

Read the full paper, which includes mini case studies that illustrate how Starbucks, Merhology, Tiffany, BigMouth Inc. and Starc Systems optimized working capital, here.

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