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Chapter 4 of 6 · 12 min

Working capital and cash flow

Why a growing, profitable business can run short of cash: money tied up in receivables and inventory.

By the end of this chapter you can
  • Turn changes in DSO, inventory days and DPO into dollars
  • Calculate the change in net working capital and its effect on cash flow
  • Explain why working capital never touches net income
  • Work back from a cash impact to the change in supplier payment terms
1

The intuition

A bakery sells $1,000 of bread to a café, but the café pays in 30 days. The sale counts as revenue today, so profit is up, but there is no cash in the till. That $1,000 sits on the balance sheet as a receivable: money earned but not yet collected.

The same bakery buys flour on 30-day terms. It has the flour now and pays later: that is a payable, and it works like a free loan from the supplier. Flour and bread sitting on shelves is inventory: cash already spent that has not yet turned back into sales.

The key idea

Working capital is cash tied up in running the business. When receivables or inventory grow, cash is stuck; when payables grow, suppliers are funding you. Cash flow moves opposite to net working capital, one for one.

2

Why it works

  • Net working capital, in these questions, is receivables plus inventory minus payables.
  • Days measure it. DSO (days sales outstanding) is how long customers take to pay; inventory days is how long stock sits; DPO (days payables outstanding) is how long you take to pay suppliers.
  • Days turn into dollars. Receivables run off revenue, so one day of DSO is revenue ÷ 365. Inventory and payables run off cost of goods sold, so one day is COGS ÷ 365.
  • On the cash flow statement, an increase in receivables or inventory is subtracted from cash from operations; an increase in payables is added.
  • Net income never moves. Working capital changes when cash arrives or leaves, not whether revenue or costs are recognized.
Revenue $365M, cost of goods 60% ($219M)
DSO up 5 days: 5 × $1.0M a dayreceivables +5.0
Inventory days up 3: 3 × $0.6M a dayinventory +1.8
DPO up 4 days: 4 × $0.6M a daypayables +2.4
= Change in net working capital: 5.0 + 1.8 − 2.4+4.4
= Change in cash from operations−4.4
3

The formulas

Δ Receivables = revenue ÷ 365 × Δ DSO

Each extra day customers take to pay ties up a day of sales.

Δ Inventory = COGS ÷ 365 × Δ inventory days

Each extra day on the shelf ties up a day of cost of goods.

Δ Payables = COGS ÷ 365 × Δ DPO

Each extra day you take to pay suppliers keeps a day of costs in your bank.

Δ Net working capital = Δ receivables + Δ inventory − Δ payables

Uses of cash, minus the source.

Δ Cash from operations = − Δ net working capital

Opposite sign, one for one.

4

Worked example

Days in, dollars out. Convert each change into dollars first, then combine them.

Drawing the numbers…
5

See it move

Same company. Change how fast customers pay, how long stock sits and how slowly the company pays its suppliers.

Drawing the numbers…
Try this
  • Push DSO up. Receivables grow and cash from operations falls by the same amount, while net income never moves.
  • Push DPO up. Payables grow and cash rises: the company is borrowing from its suppliers.
  • Move DSO and DPO by the same number of days. A day of DSO moves more cash, because receivables run off revenue and payables off the smaller cost of goods.
  • Double the revenue with the days held fixed. Every dollar figure doubles.
6

Run it backwards

Same company, reversed: you know what happened to cash, DSO and inventory days. What did the company do to its supplier payments?

Drawing the numbers…

Work the bridge from the other end. The cash impact, with its sign flipped, is the change in net working capital. Take out the receivables and inventory moves, and what is left is the change in payables. Divide by a day of cost of goods (COGS ÷ 365) to turn it back into days.

In a real company this is how you catch a quarter flattered by stretching suppliers: operating cash flow looks strong, but DPO jumped.

7

Traps

Saying a rise in receivables increases cash because receivables are an asset.
The revenue was booked but the cash was not collected. Any growing asset other than cash uses cash.
Using revenue for inventory days and DPO.
Inventory and payables are measured against cost of goods sold. Only receivables run off revenue.
Getting the payables sign backwards.
Payables are a source of cash: when they grow, cash rises.
Putting working capital changes through net income.
They are balance sheet movements. Net income is unchanged; only the cash flow statement adjusts for them.
Treating more payables as pure good news.
It frees cash, but it is borrowing from suppliers. Stretch too far and you lose discounts, strain relationships or signal distress.
8

Say it in the interview

The interviewer asks

“Why can a profitable, fast-growing company run out of cash?”

Say yours out loud first, then compare.
9

Check yourself

4 fresh questions, with new numbers. Answer each one correctly to finish the chapter. Get one wrong and you will see the full working, then you can try it again with new numbers.

Answers within 1% are marked right. Type the number; $, %, x and M are fine. First tries count toward Learned: the topic is Learned once every chapter is done and 75% of first tries were right.

0 of 4
Drawing your questions…
Remember
  • Net working capital = receivables + inventory − payables.
  • DSO runs off revenue; inventory days and DPO off cost of goods.
  • Cash from operations moves opposite to net working capital, one for one.
  • Working capital never touches net income.