Working Capital in Corporate Finance: Cash, Profit, and Operating Decisions

1) Working capital: the balance-sheet view of short-term funding

Working capital is defined as current assets minus current liabilities. It captures how much short-term capital is tied up (or released) by day-to-day operations.

• Current assets: cash, accounts receivable (A/R), inventory, and other assets expected to turn into cash within ~12 months.
• Current liabilities: accounts payable (A/P), accrued expenses, short-term debt, and other obligations due within ~12 months.

A useful operational subset is net working capital (operating):

• Operating current assets: A/R + Inventory (often excluding excess cash)
• Operating current liabilities: A/P (and sometimes accrued operating liabilities)

This chapter separates two ideas that are often mixed up:

Working capital is where profitability and liquidity collide: operations can be profitable while still consuming cash because cash timing rarely matches revenue timing.

2) Mapping typical transaction flows to balance sheet accounts

Most operating cash timing differences come from three accounts: receivables, inventory, and payables. They translate operational decisions (sell, buy, stock) into balance-sheet movements.

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A. Sell on credit (creates accounts receivable)

Operational event: You deliver a product/service today, but the customer pays later (e.g., Net 30).

Balance sheet impact at the moment of sale:

• A/R increases (you are owed cash)
• Inventory decreases (if you sold goods)

Income statement impact:

• Revenue increases now (when earned, not when collected)
• COGS increases now (matching the sale)

Cash impact today: often no cash yet. Cash arrives when the customer pays; until then, cash is tied up in A/R.

B. Buy on terms (creates accounts payable)

Operational event: You receive inventory or services from a supplier today, but you pay later (e.g., Net 45).

Balance sheet impact at receipt:

• Inventory increases (or expense/prepaid depending on what you bought)
• A/P increases (you owe cash later)

Income statement impact:

• If inventory: no immediate expense; expense appears later as COGS when sold
• If services: expense may be recognized as incurred

Cash impact today: often no cash outflow yet. Payables act like short-term financing from suppliers.

C. Stock inventory (ties up cash before revenue exists)

Operational event: You purchase goods to hold for future sales.

Balance sheet impact:

• Inventory increases when purchased/received
• Cash decreases when paid (immediately or later depending on terms)

Key point: Inventory is cash that has been converted into goods. It becomes cash again only after (1) sale and (2) collection.

3) How the same sale can increase profit while reducing cash (short term)

Because accounting recognizes revenue when earned and expenses when incurred (accrual accounting), profit can rise even if cash falls. The most common driver is a credit sale that increases A/R.

Step-by-step example: profitable month, negative cash impact from working capital

Assume a company sells $10,000 of goods on Net 30. The goods cost $6,000 (COGS). The company pays suppliers immediately for simplicity.

• At sale (Day 0):
  • Income statement: Revenue +$10,000; COGS +$6,000; Gross profit +$4,000
  • Balance sheet: A/R +$10,000; Inventory −$6,000
  • Cash: $0 collected today
• Supplier payment (Day 0):
  • Cash −$6,000
  • No additional income statement effect (COGS already recognized at sale)
• Collection (Day 30):
  • Cash +$10,000
  • A/R −$10,000
  • No new revenue (already recognized)

What happened? Profit increased immediately by $4,000, but cash decreased by $6,000 at first (because cash left to fund the inventory before the customer paid). Until collection, the business is profitable on paper but must finance the gap.

In practice, the gap can be larger because companies also pay wages, freight, and overhead before collecting from customers.

4) Receivables, payables, and inventory as cash timing levers

These three accounts are not just “accounting buckets”—they are operational-financial levers:

• Receivables (A/R): how quickly customers pay. More credit or slower collections usually increase sales flexibility but consume cash.
• Inventory: how much you stock and how fast it moves. More inventory can protect service levels but ties up cash and increases holding risk.
• Payables (A/P): how you manage supplier terms. Longer terms preserve cash but can affect pricing, reliability, or supplier relationships.

Working capital management is about balancing service levels, growth, and risk while controlling the cash tied up in operations.

5) Cash conversion cycle (CCC): the operational-financial bridge

The cash conversion cycle measures how long cash is tied up from paying suppliers to collecting from customers. It connects operating decisions (inventory levels, credit terms, collections) to liquidity.

A common formulation:

CCC = DIO + DSO − DPO

• DIO (Days Inventory Outstanding): average days inventory is held before sale.
• DSO (Days Sales Outstanding): average days to collect after a sale.
• DPO (Days Payables Outstanding): average days before paying suppliers.

Interpretation: A higher CCC means cash is tied up longer. A lower CCC means operations recycle cash faster (all else equal).

Why CCC matters in operating decisions

• Sales teams may push longer customer terms to win deals (DSO increases).
• Operations may increase safety stock to avoid stockouts (DIO increases).
• Procurement may negotiate longer supplier terms (DPO increases), which can offset the cash impact of higher DIO/DSO.

CCC turns these choices into a single time-based metric that finance and operations can discuss together.

6) Mini-case: track one product from purchase to collection (where cash gets tied up)

This mini-case follows a single unit through purchase, storage, sale, and collection. The goal is to see exactly when profit is recorded versus when cash moves.

Case setup

• One unit purchase cost: $60
• Sale price: $100
• Supplier terms: Net 30 (pay supplier 30 days after receipt)
• Customer terms: Net 45 (collect 45 days after delivery)
• Inventory holding time before sale: 20 days

Assume no other costs to keep the focus on working capital mechanics.

Timeline with balance sheet, profit, and cash impacts

What this reveals (step-by-step)

• Profit is recorded at Day 20 when the sale happens: +$40 profit appears even though cash has not moved.
• Cash is tied up from Day 30 to Day 65: the company has paid the supplier but has not yet collected from the customer.
• The cash gap length is driven by timing: inventory days (20) + receivable days (45) − payable days (30) = 35 days of cash tied up.

In CCC terms for this single-unit path:

DIO = 20 days (held before sale) DSO = 45 days (wait to collect) DPO = 30 days (wait to pay) CCC = 20 + 45 − 30 = 35 days

Operational levers illustrated by the case

• If you reduce DIO (sell faster, better forecasting, less safety stock), cash is tied up for fewer days.
• If you reduce DSO (tighter credit policy, faster invoicing, better collections), cash arrives sooner.
• If you increase DPO (negotiate longer terms), you delay cash outflows—though this may affect supplier pricing or reliability.