/>iProfitability vs. Liquidity
Many business owners and professionals have encountered a puzzling scenario: their profit and loss statements indicate strong earnings, yet the bank balance tells a different story. This discrepancy is often due to a lack of understanding of a fundamental concept: working capital.
This article explores the dynamics of working capital and its central role in a company’s financial health.
Working Capital Defined
Working capital is typically calculated as current assets minus current liabilities. While working capital is a calculated figure, liquidity is the practical reality of whether those assets can be accessed in time to meet obligations. A company may report strong working capital, yet struggle to cover payroll if receivables are delayed or inventory is illiquid. Natasha Perssico Escobedo of Epstein + Nach LLC emphasizes that companies should also consider the quality of the assets in addition to their liquidity.
Working capital can be broken down into the following categories:
- Gross Working Capital: The sum of all current assets.
- Net Working Capital: Current assets minus current liabilities.
- Permanent Working Capital: The baseline level required for ongoing operations.
- Temporary Working Capital: Additional short-term needs due to seasonal fluctuations or unexpected events.
Current Assets and Liabilities: A Closer Look
Current assets include cash, accounts receivable, inventory, and marketable securities — items expected to be converted into cash within a year.
Current liabilities include accounts payable, accrued expenses, short-term debt, warranty obligations, and unearned revenue.
John Levitske, partner at HKA, points out that many current liabilities mirror the operations tied to current assets. For example, if a business accepts prepayments or has large payables from vendor purchases, these need to be managed in tandem with asset conversion to avoid liquidity issues.
Terry Orr, partner at HKA, highlights the nuances in how assets and liabilities are classified as ‘current.’ While generally defined by a 12-month timeframe, he notes that industries with longer cycles, such as construction or agriculture, may require more tailored metrics. The key takeaway: improper classification or inadequate forecasting can lead to unexpected cash shortfalls.
Cash as a Strategic Asset
Cash is the most liquid asset and the foundation of financial flexibility. Companies with healthy cash reserves are better positioned to weather downturns, respond to market shifts, or pursue strategic acquisitions. Many large firms, such as Berkshire Hathaway and Apple, maintain significant cash holdings as a matter of long-term planning and risk management.
Ken Yager, President of Newpoint Advisors Corporation, agrees cash is an essential asset, but observes that timing plays an equally critical role. He highlights that the speed with which assets are converted into cash, such as the collection of receivables or the sale of inventory, has a direct impact on liquidity. A business may have sufficient assets but still struggle if those assets are not readily accessible.
Understanding the Cash Conversion Cycle
The cash conversion cycle is the time it takes to turn investment in inventory into cash through sales and collections, minus the time a company can delay paying its own bills. This metric helps companies measure efficiency and identify bottlenecks in cash flow.
However, companies should not rely solely on one metric. Forecasting based on other trends such as ‘days sales outstanding (DSO),’ ‘inventory turnover,’ and ‘days payable outstanding (DPO)’ allows businesses to anticipate future cash needs and avoid surprises.
Escobedo suggests modeling scenarios ranging from best-case to worst-case to strengthen both internal controls and external confidence.
A Word of Caution: Relying Solely on EBITDA
In a hypothetical scenario posed by Candice Kline, Assistant Professor at the University of Toledo, a company with $12 million in projected EBITDA and minimal monthly expenses may seem financially sound. However, Kline explains that without evaluating changes in working capital, such optimism can be misplaced. EBITDA doesn’t reflect delayed receivables, bloated inventory, or vendor payment terms, all of which directly affect cash flow.
Strategic Working Capital Management
Effective working capital management requires more than knowing the formula. It means understanding the timing, quality, and context of your assets and liabilities.
Strong working capital practices support not only liquidity, but also growth, creditworthiness, and resilience. Mastering this concept is essential for informed decision-making and long-term success.
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To learn more about this topic view MBA Bootcamp / Where Did All My Profits Go? Mastering the Concept of Working Capital. The quoted remarks referenced in this article were made either during this webinar or shortly thereafter during post-webinar interviews with the panelists. Readers may also be interested to read other articles about business management.
This article was originally published here.
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