Running out of cash (and how to avoid it)

Hey there,

In this issue, you will learn:

1. True Operating Working Capital
2. How to Calculate the Working Capital Gap
3. Strategies for Managing the Working Capital Gap
4. Why this is important for your business

In the normal course of business, a product or service is sold, cash is generated, and the profits are used to expand and grow.

Do this a few more rounds, you begin to scale.

Logically, a business doesn't plan to scale linearly. It's usually planned for exponential growth. But for this creates a problem.

To sell, the product must be available and to source this product, you need cash. To source enough product for exponential growth, you likely won't have enough cash.

This phenomenon is called the working capital gap.

1. True Operating Working Capital

Working capital is the lifeblood of any business, and understanding the working capital gap is crucial for effective financial management. Normally, the working capital gap represents the variance between a company's current assets and current liabilities, which is a good measure of short-term liquidity.

More specifically, my definition of working capital is accounts receivables plus inventory minus accounts payable. To help you understand, let's think about this from a timeline perspective.

Accounts receivable ("AR") is the amount owed to you from customers. On the timeline, AR days is the number of days it takes for AR to be collected from point of sale. The larger the AR, the more cash is stuck. I call this cash negative.

Inventory ("Inv") is the amount of product you have to sell. Inv days is the number of days inventory is held before point of sale. The more inventory held, the more cash is stuck; again, cash negative.

Accounts payables ("AP") is the amount you own to your vendors (cash positive). AP days is the number of days it takes to pay vendors. The more AP, the more cash is held. This is cash positive.

Circling back to the business scaling idea, exponential growth means higher amounts of AR and Inv. This means cash negative items will increase, exponentially. On the other hand, AP will increase, but not to the extent of both AR and Inv.

On the timeline, a simple cash conversion cycle looks like this:

In the example above, it takes 90 days (120-30) between paying vendors to collecting cash.

Can you see how this will be a problem as you scale?

The goal is to unlock cash for growth. Instead, what is happening is larger amounts of cash being stuck as you grow.

To solve this problem, we must understand the working capital gap.

2. How to Calculate the Working Capital Gap

First, let's calculate the cash conversion cycle.

Cash Conversion Cycle = AR days + Inv days - AP days

AR days = AR / Credit Sales * 365

Inv days = Inv / Cost of Goods Sold * 365

AP days = AP / Cost of Goods Sold * 365

Next, let's calculate the working capital gap.

Working capital gap = Projected Sales / Cash Conversion Cycle * 365

Note: Projected sales is used as a proxy for expected cash requirements based on projected sales volumes.

The working capital gap is the amount of money that is tied up within the business' operating cycle.

Now that you have the working capital gap, we need to fill this gap.

Why?

Because a business needs cash to operate. Employees need to be paid or they stop working. Suppliers need to be paid or they stop shipping inventory.

Note: If your working capital gap is negative, your business falls into the lucky bucket of being a cash cow. In this case, customers often pay upfront upon delivery while the business has extended terms to pay suppliers. Think of Costco and Wal-Mart.

3. Strategies for Managing the Working Capital Gap

While there are many different ways to manage the working capital gap, it boils down to 2 strategies:

• Shorten the cash conversion cycle: Shortening AR and Inv days means cash is collected sooner. Stretching out AP days delays the payout of cash. The combination of these reduce the working capital gap.
  • The various techniques to optimize AR, Inv, and AP are extensive and is beyond the scope of this newsletter issue. Feel free to send me a note if interested. This topic will be shared in a future issue.
• Secure working capital financing: Working capital financing is typically provided by a bank in the form of a line of credit or revolver. Alternatively, loans from private lenders, family, or your savings can help, albeit at a higher cost.

Each of these options come with a cost (i.e. interest cost, managing customer/supplier relationships, etc.). It's up to you to decide which lever to pull.

4. Why this is important

With all that is said above, I want to nail the hammer on its head. Identifying company's working capital gap is crucial step in planning for its future growth.

If you don't understand the gap, you may dig a hole too deep to see light at the end of the tunnel.

Remember, cash is king. Not profitability.

Cash keeps the lights on, employees working, and most importantly, it keeps the business moving.

Understanding the working capital gap helps you:

• Plan your cash requirements ahead of time.
• Know your cost of funds to make decisions to price future inventory purchases, projects pricing, and etc.
• Manage customer and supplier relationships by knowing when and how much to lean on the terms given/provided.

Most importantly, it helps you make sure you don't run out of cash.

That's it for this week. See you next Saturday.

Thank you for reading Financing Journey. I hope you've enjoyed this issue. If you think this would be helpful to anyone you know, please share this newsletter and connect with me on X and LinkedIn for daily financing tips.

Have a topic you'd like me to cover? Email me at hello@lawrencefan.com.