Working capital refers to the funds that a business uses to manage its day-to-day operations. It is calculated as current assets minus current liabilities. Effective management of working capital is crucial for maintaining liquidity and ensuring that a company can meet its short-term obligations. It also has implications on your business runway and equity ownership.

Working capital and the cash conversion cycle

Your working capital need is simple to calculate by breaking current assets and liabilities into its three components: inventory, sales and payables and their turnaround time, DPO, DSO, and DIO. Together they make up the so-called cash conversion cycle, CCC.

CCC = DIO + DSO - DPO

Here’s what each of them means:

• DPO (Days Payable Outstanding): This measures how long a company takes to pay its suppliers. It indicates the efficiency of a company in managing its payables. A higher DPO means the company is taking longer to pay its bills, which can help conserve cash in the short term but may also affect supplier relationships.

  DPO = (Accounts Payable / Cost of Goods Sold) * 365

  
  

• DSO (Days Sales Outstanding):This metric assesses how long it takes for a company to collect payment after a sale has been made. It reflects the effectiveness of the company's credit and collection policies. A lower DSO indicates that the company is collecting its accounts receivable more quickly, improving cash flow.

  DSO = (Accounts Receivable / Total Credit Sales) * 365

  
  

• DIO (Days Inventory Outstanding):This measures how long inventory is held before it is sold. It indicates how efficiently a company is managing its inventory. A lower DIO suggests that a company is selling its inventory quickly, contributing to better cash flow.

  DIO = (Inventory / Cost of Goods Sold) * 365

Together, these metrics help businesses understand their cash conversion cycle, which is the time taken to convert investments in inventory into cash flows from sales. This cycle is crucial for managing overall working capital effectively.

To calculate the working capital need, simply calculate:

Working capital = Inventory value + Average AR value - Average AP value

Why is this important?

Understanding how the working capital & the cash conversion cycle impact your business runway and equity ownership can help in effective financial planning and management.

Here’s how these aspects intersect.

Working capital and business Runway

Business runway refers to the amount of time a company can operate before it needs new funding or must become self-sustaining. Impact on working capital:

• Liquidity Management: A shorter CCC means that a company can quickly convert its investment in stock into cash, improving liquidity. This allows the company to use otherwise tied funds on more high-value initiatives, such as investing in additional growth opportunities and extending the company’s runway.

• Capital  Efficiency: Companies with efficient CCC can minimize the need for external financing, as they need to rely less on debt to maintain operations. This efficiency strengthens the runway and allows the business to invest its funds in growth rather than debt repayment.

• Operational efficiency: A low CCC opens up for improved flexibility in your business. This could be important for example when discussing terms with suppliers, and enable potential discounts through early repayments or more favorable credit terms, which can further improve margins. Reduced inventory levels also have the potential to reduce wastage & obsolescence of your stock, which will further boost profitability.

Working capital and equity ownership

Equity ownership refers to the ownership stake that shareholders have in a company, typically represented by shares of stock. Impact on working capital:

• Dilution of Ownership: If a company has a long CCC and struggles with liquidity, it may need to seek external financing, such as equity investors. This can dilute existing ownership percentages among current shareholders, as new shares may be issued to raise funds.

• Attractiveness to Investors: Companies that demonstrate an efficient CCC are often more attractive to investors because they exhibit strong management of resources and cash flow. This can lead to higher valuations at more favorable terms.

Summary

In summary, working capital has a significant impact on both business runway and equity ownership. A shorter CCC, requiring less working capital, allows a company to operate more efficiently, maintain liquidity, and minimize the need for external funding, thereby extending its runway and preserving equity ownership for existing shareholders. Conversely, a longer CCC can lead to operational challenges, potential dilution of ownership, and a higher reliance on external capital, which can impact long-term growth and control of the company.