This is CFO Secrets. The weekly newsletter with serious finance chat behind a silly cartoon face.

10 Minute Read Time

In Today’s Email:

• 🛞 Winning at Working Capital

• 👻 Why I’m Anonymous

• 😱 The Open AI Debacle

I am now accepting applications to sponsor this newsletter for 2024. I will be working with a small number of carefully selected partners. If you are interested click here.

A WORD FROM THIS SEASON’S SPONSOR…

THE DEEP DIVE

Making Working Capital Work

This is the sixth week in an 8 week season covering how to build a culture of cashflow obsession in your business.

Early in my career I worked for a retail business.

They were growing like a weed; rolling out new stores every week.

A machine.

The first time I saw the new store business case, it blew my mind.

Here are the numbers (Roughly … it was a long time ago):

• Capex cost per new store: $10m

• Average Annual Revenue Per Store: $30m

• Marginal EBITDA generated at maturity: $2m

So a simple Pre Tax Return on Capital was 20%.

Good, but not exceptional.

But here’s the bit that changed how I thought about finance and capital, forever.

Half of the capital got paid back inside 3 months of the new store opening.

How?

Negative Working Capital.

Here’s how it worked:

• They expected to hold 15 days of inventory

• Receivables were close to 0 (cash sales)

• Payables were 75 days.

They had a negative working capital cycle of 60 days (15 + 0 - 75).

These 60 days were worth roughly $5m of cashflow per new store.

By the end of the third month, $5m of the $10m capex had been returned by way of working capital inflow. Often before the store had even made a dime of profit.

This had two effects:

• The return effectively doubled to 40%. $2m maturity EBITDA earned on $5m net investment.

• The capital budget would go twice as far. For a budget of $500m, you could get 100 stores instead of 50.

Now imagine that effect compounding over a decade or more?

Incredible.

It was one of those moments that I couldn’t unsee.

I never looked at a balance sheet the same way again.

Let’s start with the basics:

What is Working Capital?

Working capital is the funding a business needs to meet its short term obligations. The subset of assets and liabilities that cycle through the business quickly. I.e. in less than 12 months.

Working Capital is one part of the capital structure of a business.

Capital Structure = Long Term Capital + Working Capital.

Long term capital tends to be static. And is well suited to long term funding sources; equity and debt.

Working capital is volatile. It moves fast with:

• Changes in fundamentals (inventory days and payments days up or down)

• Growth or decline in size of business (and mix effects)

• Seasonality (month by month variations)

Working Capital is well matched to short term sources of funds. Cash, overdrafts, specialist working capital facilities.

Flexibile funding is the antidote to volatility. But flexible funding is expensive. Tight management of the fundamentals is critical to minimize exposure to expensive flexible funding.

Defining Working Capital

The formula for working capital is as follows:

Working Capital = Receivables + Inventory - Payables + Cash Float

Note: Final point is cash ‘float’, not cash balance. Bare with me before you get your pitchforks out…

• Receivables (inc Prepayments). Money you are owed by customers or 3rd parties from normal trading

  • Prepayments. Things paid for before they get used.

• Inventory. The value of goods and work in progress held for future sale

• Payables (inc Accruals and Deferred Income). Amounts invoiced by suppliers not yet paid

  • Accruals. Costs incurred not yet invoiced by suppliers

  • Deferred Income. Cash received from customers for services not yet delivered. Common with SaaS on annual plans for example.

• Cash Float. The minimal amount of operating a cash a business needs to function. This is not the same as cash balance.

  • A retail store that holds $50 of cash in its cash register every night as a float, would form part of its working capital. That $50 is a permanent investment in the business. Think of it like an extension of receivables

  • Likewise. If your business, keeps a minimum amount of $5m in the bank, because that’s what it needs to manage the weekly payment cycle... that’s working capital. Maybe not in name, but in substance.

Working capital is easy to calculate at a point in time. These numbers can be lifted from the balance sheet. Except for cash float which can be calculated/estimated (days of expenses needed on hand).

It’s complexity comes from the way it moves.

Working Capital is most often a positive number.

Positive Working Captial: Where Receivables + Inventory + Cash Float > Payables.

Positive working capital needs money to fund it.

But working capital can also be a negative number. As it was in the retail business I described.

Negative Working Capital: Where Payables > Receivables + Inventory + Cash Float.

In this situation, working capital produces funding rather than needs it.

Let’s use an extreme example, to illustrate the point:

• Business A & B, do the same thing, and are the same size.

• Business A customers pay 90 days following invoice

• Business B customers pay 50% upon order, and 50% gets paid 30 days following invoice

The working capital shape would look something like this for those two businesses:

Business A has $100 of positive working capital. Business B has $30 of negative working capital.

The difference between the two is $130. Business A’s funding need is $130 higher than Business B.

That is permanent funding that Business A needs to find, that Business B does not.

And it’s a quarter of the value of annual sales. Huge.

But that’s not the only difference.

Working Capital & Growth

Imagine both businesses are growing sales by 20%. Let’s see what year 2 looks like:

Note - To keep the example simple, we’ve assumed no scale economies in working capital. They would likely apply equally to both scenarios anyway.

If sales grow by $100 in Business A, the working capital need grows by $20. There are more receivables to fund (partially offset by higher payables).

Likewise in Business B, the negative working capital grows by $6. Increasing the gap between the two further. Here, receivables and inventory have grown. But payables and deferred income have grown by more.

Here’s the interesting bit…

Impact on Net Cashflow

Imagine a 15% contribution margin earned on both businesses. I.e. for those extra $100 of sales, they each earn an extra $15 of profit:

Business A has to invest all that $15 of profit, plus a further $5, to fund that sales growth. I.e. The extra sales actually had a cash effect of negative $5.

This doesn’t mean Business A is a bad business. We have only looked at first year impact here. That $15 of contribution on the $100 of sales will repeat each year. Whilst the working capital (for an isolated year of growth) will not.

But let’s compare that to Business B, where not only is the $15 of profit free cashflow. But $6 of negative working capital get released too, meaning the $100 of sales creates $21 of new cashflow.

But it doesn’t stop there…

We have looked at these as parallel examples.

In practice Business B, has that $21 to reinvest. Fuel for the rocket. Marketing. Capex. This creates a flywheel of compound growth.

It won’t be long before these two businesses look nothing like each other.

This is how the retail business at the start of this post was able to use suppliers to fund half its store expansion program.

Negative Working Capital in Practice

May I have your permission to rant for a moment? Thank you.

When I make this point, I often get responses complaining about ‘bullying suppliers’. Or ‘ridiculous expectations of customers.’

This is lazy thinking. It misses the point.

Suppliers and customers are not idiots. They find ways to work together that work for everyone. Or they don't accept it. Maybe those suppliers are bigger with stronger balance sheets. And access to cheaper funding, so they are happy to fund growth.

And maybe the business that demands longer supplier terms is prepared to pay higher prices? Or offer a discount to customers for a large deposit with orders.

It's economics.

And besides, some business models have this shape built in.

What’s the secret of Warren Buffett’s wealth? There are many, of course. But there is one dynamic that exploded his wealth quicker than any other. Insurance float.

Buffett owns GEICO. GEICO (a general insurer) collects premiums years before it makes payouts. This phenomenom is called Insurance Float.

Buffett invested the float, into growing GEICO and other high income producing assets. This created a compounding juggernaut.

Jeff Bezos used this same phenomenon to grow Amazon in the early years. Back when it was a scrappy start up, not the big boy it is today. Bezos got Amazon to Free Cash Flow Positive, a long time before it was able to break even on the P&L.

Negative working capital was how he did it.

These are extreme examples to illustrate the point. And in practice the trade-offs may not be so big.

But the compound effect of small changes in the design of working capital over many years can be huge.

Working Capital is Your Business Model

The key point is this.

Working capital design is part of your business model.

It as much your business model as your unit economics.

Businesses tend to fix their unit economics (i.e. profit per unit) first. And then find the best possible working capital model to fit those unit economics.

This is the wrong way.

Instead, think about unit economics on a marginal cash basis, rather than a marginal profit basis. Especially in a growth business.

Bootstrap entrepreneurs are phenomenal at this.

They find ways to get paid before they work. And they find ways to get suppliers to work before they are paid.

It’s survivorship bias. Those that work it out survive, so are good at it, and so on. Those that don’t, often die.

They design their business around their working capital cycle. Most businesses do not do this. Do not be most businesses.

The Counter Factual - Watch Outs

Negative working capital is wonderful if you are growing.

It is horrible if you are shrinking. I’ve been there. It’s awful.

Sales are going backwards, and you are burning cash at a rate even faster than your business is losing money. A doom loop.

There are two sides to the negative working capital cycle coin.

As there is to positive working capital.

Imagine a large mature business with tight margins and positive working capital.

If this business reduces sales, closes business units, etc, this might lead to losses. But also positive cashflow as working capital unwinds. (Think of Business A above but with sales $200 lower):

Assuming a margin again on sales of 15%, $200 of lower sales would reduce profit by $30. But $40 of working capital would be released.

Meaning cashflow would actually increase by $10.

This can be used to justify a litany of corporate sins. Marginal decisions justified in the micro. But criminal at a macro level. Look hard enough, and you’ll see it everywhere.

You could probably find an argument to wind up Business A to zero if you were conservative enough.

Your job as management is to find ways to invest the assets of your investors to deliver great long term returns. Shrinking your way to glory is rarely the answer.

COVID provided an interesting challenge on working capital. During the lockdown. As the economy shut down, businesses enjoyed the cash windful of their positive working capital unwinding. It helped fund the costs of standing still.

But, boy, did that hurt when those businesses had to restart again. And rebuild that working capital.

Seasonality

We haven’t even talked about seasonality of working capital, and the effect that has.

Spare a thought for those Christmas Light manufacturers who have 12 months of inventory on their books right now.

Seasonality of working capital is such a big topic, we'll have to save it for another time.

Homework

1. Plot working capital by component against your business activity over time

2. Establish what the leading indicator is for working capital in your business. Is it sales? Define the KPI.

3. What is it about your business model that makes your working capital cycle what it is?

4. What would need to be true for your business to have a negative working capital cycle? What would need to change? How do you put it at the front of your business?

5. How could you make those changes? Think big here. For a big change in working capital, you might need a change in your business model. A new partnership. Remodel the supply chain. A reduced margin expectation?

6. Is it worth it? What is the trade off? What would you have to give up for a better working capital cycle? Is it worth it?

This will set the ground nicely for next time.

Now we all think about working capital the same way, after a one week break we will get into tactical tips for improving working capital.

THIS WEEK ON SOCIAL MEDIA

For those that wonder why I write under a pseudonym …

Following the Sam Altman / Open AI story on Twitter has been incredible. This was the funniest take:

FEEDBACK CORNER

A review of the last post:

Lol. I censor the swear words because some email domains reject emails with them in.

WORK WITH THE SECRET CFO

• Hire a CFO from the Secret CFO audience

• Sponsor CFO Secrets Newsletter

AND FINALLY…

I’ll be taking a one week break next week. Back on Saturday December 9th with the final two parts of this series. The next part will be a super tactical post on what you can do today to improve your working capital cycle.

As always you can find me here:

• CFO Secrets

• Twitter

• LinkedIn

Finally, thank you once again to today’s sponsor; Netsuite. Check out their ‘CFO Daily Checklist’ here.

Stay Crispy,

The Secret CFO

Disclaimer: I am not your accountant, tax advisor, lawyer, CFO, director or friend. Well, maybe I’m your friend, but I am not any of those other things. Everything I publish represents my opinions only, not advice. Running the finances for a company is serious business, and you should take the proper advice you need]p