The Importance of Managing Working Capital in Small Business
April 06, 2012 - 1 min read
Working capital is the short term liquidity (read: cash) required to operate a business. Working capital is defined as Current Assets (primarily accounts receivable and inventory) less Current Liabilities (primarily accounts payable).
When Current Assets increase (inventory goes up), cash goes down. When Current Assets decline (inventory goes down), cash goes up. Likewise, when Current Liabilities increase (payables go up), cash goes up. When Current Liabilities decline (payables go down), cash goes down.
Each of our portfolio companies have different working capital "situations", some more advantageous than others.
Our magazine publishing company has the most traditional working capital situation. When it sells advertising, customers generally receive terms (net 30) and so the company carries accounts receivable from advertisers. Current Assets up, cash down. The company also owes money to various vendors that we work with including our printer, freelance writers, etc. It carries these as accounts payable. Current Liabilities up, cash up.
This is about as simple or traditional a working capital arrangement a business can have and results in some matching between cash uses (increase in receivables) and cash sources (increase in payables).
Our event rental company has an advantageous working capital situation. It collects deposits from customers in advance of completing a job. These customer deposits are a current liability. Current Liabilities up, cash up. At the completion of the job, it typically receives final payment. A receivable is created and instantly paid. Current Assets down, cash up. Some of it's vendors provide terms so it carries account payables. Current Liabilities up, cash up. Cash up, cash up, cash up. Hard to beat that arrangement.
Our eye-wear distribution company has a disadvantageous working capital situation. Like most distributors, it buys inventory from suppliers that require substantial upfront deposits before they will begin manufacturing product, then an additional payment when the product ships. These deposits are Current Assets. Current Assets up, cash down. The company makes a final payment when the product hits it's warehouse and becomes inventory. Current Assets up, cash down. The company sells the product to its customers on terms of Net 30, creating accounts receivable. Current Assets up, cash down. The company carries some accounts payable, helping to offset the significant amount of inventory and accounts receivable. Current Liabilities up, cash up. Overall, the working capital position is pretty rough. Cash down, cash down, cash down, cash up.
Managing working capital is critical to the cash flow of any small business. Small businesses with disadvantageous working capital positions may require a working capital line of credit (also know as an asset-based revolver or revolving loan) in order to finance operations, particularly during periods of rapid growth.
Paul joined Scott and Clay to raise Hadley Capital Fund I. He grew up in a family business environment and has spent his entire career working with small and emerging companies.
He currently works with Equustock, GT Golf Supplies, Open Sky Media, Pneu-Con, and Storflex. Previously he was the chairman of the board of directors for i-deal Optics and Centare, both former Hadley companies.
Paul is an outdoor enthusiast who enjoys fishing, hunting, riding motorbikes, Crossfit and an occasional craft beer. He works closely with a number of non-profit organizations including One Acre Fund and Trout & Salmon Foundation.
Paul is a graduate of the University of Colorado at Boulder and received an MBA from the Kellogg School of Management at Northwestern University. He and his wife, Rosemary, have three children.