Working capital requirement

Working capital — the cash engine of day-to-day operations

Working capital is the money a business has available to fund its operating cycle — buying inventory, paying employees, and running operations while waiting to collect from customers. It's not profit; it's liquidity. A highly profitable business can face a working capital crisis if it grows faster than its cash collection cycle allows.

Positive vs negative working capital — when each is fine

Positive working capital is the normal healthy state for most businesses. You hold more in receivables, inventory, and cash than you owe in the near term.

Negative working capital is actually an advantage for businesses that collect before they pay. Amazon charges your credit card when you order. It pays its suppliers 30 to 60 days later. Every day Amazon grows, it accumulates more float — a revolving pool of cash it's essentially borrowing interest-free from customers and suppliers. Walmart operates the same way. Subscription businesses with annual prepay collect 12 months of cash up front and amortize the service cost monthly — structurally negative working capital, and entirely healthy.

Negative working capital in a manufacturing business, professional services firm, or contractor is a different story. If receivables are slow, inventory is stuck, and payables are being stretched to the limit, negative WC signals the business cannot fund its own operations — it depends on new customer receipts to pay for the last job's costs.

The cash conversion cycle in plain English

Cash Conversion Cycle = DSO + DIO − DPO.

• DSO (Days Sales Outstanding): How many days after a sale before you collect cash. Net-30 billing with customers who actually pay in 45 days = DSO of 45.
• DIO (Days Inventory Outstanding): How many days inventory sits on the shelf before being sold. If you carry 60 days of inventory, DIO = 60.
• DPO (Days Payable Outstanding): How long before you pay your suppliers. Net-30 terms you pay on time = DPO of 30.

A business with DSO 45, DIO 60, DPO 30 has CCC = 75 days. Every dollar you spend on materials sits tied up for 75 days before returning as cash. At $10M annual revenue, that 75-day cycle ties up roughly $2.05M in working capital.

The practical implication: each day you improve in CCC at $10M annual revenue frees approximately $27,400 in cash (10,000,000 ÷ 365). Reducing DSO from 60 to 45 days frees $410k. That freed cash can reduce revolving credit usage, fund capex, or pay down debt.

How to free up working capital

The three levers of CCC improvement:

• Reduce DSO: Invoice the day the job is complete (not the end of the month). Offer 2/10 net 30 early payment discounts to good customers. Automate follow-ups at 15, 30, and 45 days. Move customers from net-60 to net-30 terms on renewals. Consider factoring for chronic slow payers.
• Reduce DIO: Tighten reorder points, implement just-in-time ordering for high-turn SKUs, rationalize slow-moving inventory with markdown or return programs. ABC inventory analysis focuses attention on the 20% of SKUs that represent 80% of cost.
• Increase DPO: Negotiate longer payment terms with suppliers (net-45 instead of net-30 where the supplier will accommodate). Use supply chain finance programs to extend terms without harming supplier cash flow. Pay on day 30, not day 10 — the free float is yours.

Working capital financing options

When working capital is tight, businesses can:

• Revolving line of credit: Most flexible. Draw when receivables are high, repay as collections come in. Typical rate: Prime + 1–3%.
• Invoice factoring: Sell receivables to a factor at a 1.5–3% discount for immediate cash. Useful for growth-constrained businesses with good receivables quality.
• Inventory financing: Borrow against inventory as collateral. Higher rate than LOC; useful for seasonal businesses with inventory spikes.
• Supply chain finance: Buyer facilitates early payment to suppliers via bank; supplier gets paid fast, buyer extends payment terms. Typically reserved for larger companies with bank relationships.

Working capital in M&A due diligence

When a business is sold, the buyer typically requires a "normalized working capital" balance at close — enough working capital to keep the business running without an immediate cash injection. This is negotiated as a working capital target (often a trailing 12-month average), with dollar-for-dollar price adjustments if the closing balance is above or below target. Sellers who run down receivables or stretch payables before close get hit with a working capital shortfall on the closing statement.