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Time for a brain teaser.
Imagine you were building a house near the ocean, and your goal is to maximize the home’s value. For every 10 meters you build closer to the shoreline, the value doubles.
But there's a catch. The house is uninsurable, and, if it floods (even once)… it's worth zero.
Where do you build?
Well… If you're a geek like me (and I hope you are), you'd try to figure out exactly how close you could get to the shoreline, without risking a wipe out.
And that would mean breaking the behavior of the waterline down into its component parts:
Now, before we go any further… I haven't studied geography in over 30 years. And even then, I was terrible at it. If you know your stuff, please just hold your nose and read on regardless.
So, those components:
The mean water level. The reference point for everything else. But the mean is almost meaningless on its own; the water spends very little time actually sitting there. Like a pendulum rushing past its center point, the mean is something the water moves through, not a place it rests at.
The climate trend. And the mean isn't static. Over time, it drifts in one direction or another, pushed by broader climate forces, lunar cycles, and long-run oceanographic shifts. If you're building a house to last 50 years, you'd want to build that drift into your calculations.
The tide. High tide and low tide. Arriving roughly twice a day and broadly (but not precisely) predictable in timing. And … some high tides are higher than others. Some are lower.
The waves. Overlaid on top of the tidal movement are the waves themselves. Somewhat predictable in rhythm, but variable in size. A large wave at low tide is irrelevant. But even a small wave at the peak of a high tide could be a different problem entirely. The intricacy is in the interaction between the layers.
The spray. Above the waves, you have the spray. Maybe smaller in volume, but the least predictable. The final layer of volatility on the top. Could still soak you if everything else is stacking against you at the same moment.
The storm surge. And then, once in a while, a weather event comes along that makes all of the above forecasting feel quaint... If you're building on the shores of Lake Geneva, this would matter less. But if you are on the Louisiana Gulf Coast and not accounting for the occasional storm surge, you’ve been reckless.
So, with all of those layers of volatility, the question remains…where to build the house?
Welcome to Part 2 of this five-week series of The Secret CFO’s Playbook: Working Capital Warfare.
Last week, we defined working capital precisely and established that the design of your working capital structure is strategic. It's part of your business model.
This week, I'm seriously letting you into my brain. The mental model I'm about to share for working capital has served me through countless turnarounds and M&A deals over the last twenty years.
Man, I really should be charging for this, but hey ho, here we go…
That ramble about the ocean wasn't self-indulgence (well… maybe a little). It's the best analogy for how working capital actually behaves, why it's so hard to forecast, and what to do about it.
The position of the house on the shoreline is like the capital structure of the business. Build too far from the water, and you're overcapitalized and inefficient, leaving real value on the table (and capital is harder to find).
Build too close, and one untimely wave wipes you out.
There are a couple of ways in which the analogy isn't quite perfect. First, you can actually move the house from time to time (when you recapitalize), although not continuously. Second, you can, control the water itself (within a range). But we'll come back to both of those points later in the series.
For now, I want to map each component of the waterline to its working capital equivalent:
The Working Capital Peg (The Mean Water Level)
Beneath all the volatility, your business has a structural (or normalized) working capital need. Strip away the noise; the one-offs, the seasonality, and the timing quirks, and what remains is the underlying average working capital needed to run the business at its current scale and mix.
And, like the mean water level, its value is primarily as a reference point; it's unlikely to have much day-to-day relevance for you, or be a very reliable forecast.
In practice, most CFOs only think about the working capital peg during M&A, where normalized working capital becomes a direct value driver, and is often the last thing negotiated at the table. I wrote about this in detail here.
The peg also moves over time. Growth, mix shift, market dynamics, and strategic choices all change the structural working capital requirement of the business. A business that needed $20m on average of working capital to operate three years ago might need $35m today. Not because anything has gone wrong, but because the business is different in a good way.
But that shift does change the funding dynamic permanently.
This is a key weakness I see in most working capital forecasting. Rather than building up seasonality, cyclicality, and volatility on top of a well-understood peg, the base isn’t robust enough - so the model is kinda broken before you start.
We'll come back to this in the forecasting section later in this post.
The Seasonal Cycle (The Tide)
The predictable ebb and flow of the tide maps directly to seasonal working capital movement. The frequency is different (twelve hours versus twelve months), but the logic is identical. You know the peak is coming. You know roughly (if not precisely) when, so your job is to be ready for it.
Take a Christmas decoration manufacturer. They produce year-round, building inventory for eleven months, before it all gets called off in October and November ahead of the holiday season. One enormous peak, one long build, one sharp release. And you just pray Christmas isn't canceled (as my dad would threaten every year when I was a less well-behaved youth.)
That's an extreme example, but seasonal forces in working capital don't have to come from the environment. They can be a choice; an annual renewal cycle tied to the calendar, a budget cycle that drives customer purchasing patterns, a licensing window that opens once a year.
And of course, not every working capital profile has a single peak. Take a fireworks retailer, for instance. I don't know exactly what proportion of their annual revenue lands on July 4th and New Year's Eve, but I'd bet it's the vast majority.
Understanding where your seasonal peaks sit relative to your peg, and how you build toward them, is fundamental. Here's a simple example: a B2B business that peaks before the summer. Inventory builds steadily through the year, peaking in April. That converts into receivables in May. Which finally converts into cash in June, while the payables peak gets paid down the following month:
Plot that as a total working capital position against the peg and you’ll see the picture. The trough in June isn't the concern. Low tide isn't going to flood the house. And likewise a brief low tide is of no real use to you, it’s not like you can lay your towel out (invest the cash) … the water will be here again soon enough.
But the inventory build into April is a very real and very fundable event. It needs to be planned for, financed, and managed.
I have managed a business with extreme seasonal volatility in the past (think ~99% of annual consumption on one single day of the year). It’s very fucking difficult. Follow for more exclusive insights like this… lol.
The Monthly Rhythm (The Waves)
Sitting on top of the seasonal cycle is the predictable operating rhythm of the business. In its purest form, this will look like a simple monthly cycle, where payroll is made monthly, overheads are incurred in a single monthly pay run, and receivables are collected through a single monthly subscription date.
In practice, most businesses are much messier.
More likely it’s fortnightly payroll, receivables trickling in across the month as debt is chased down, a twice-monthly payables run (+ the occasional ad hoc). Along with some regular monthly debits, too.
And while there is more complexity, this would still be a monthly rhythm (just with multiple waves inside that cycle).
If not monthly, then your business will run on a quarterly rhythm. These are common in the UK, where the whole cash cycle can be driven by a single chunky quarterly VAT payment. How and when the corresponding receivables are collected relative to that payment can drive the whole cashflow.
But here's the problem.
Most cash and capital planning is done at a monthly or quarterly level. Models built to month ends, using historical data closed at month ends. Completely ignoring the intra-month volatility.
The implicit assumption, if you don't model it, is that your working capital need is greatest at month end. For many businesses, that simply isn't true. The peak might be on the 15th. Or the 22nd, or any other day you can choose. It depends entirely on when the big payments land relative to when the collections arrive. And the earlier in the month it lands, the harder it is to deal with.
Yes, it might be only a few days here and there. But if it's happening every single month, it's a permanent capital draw that you haven't built into your funding structure. You're consistently short, scrambling …and confused about why.
Note: signs are flipped versus the working capital convention above. This chart shows ‘direct method’ cashflow - receipts and payments - not working capital balances.
The bars are the individual cash receipts and payments by day. The red line is the cumulative cashflow for the month, which as you’ll see here is negative for the whole month until the final day, peaking at working day 15. Assuming this is repeatable, this is a real funding requirement for the business (vs a model built to month ends).
I would hazard to say that most long-term capital/cashflow forecast models I see do not account for this.
And when I see a business in serious cash pain, it’s one of the first things I look for.
The Operational Noise (The Spray)
The final layer of this chaos cake is the day-to-day operational volatility that blows the monthly rhythm sideways.
Your biggest customer starts paying a week late. A new procurement head orders earlier and more aggressively to access a discount. The CEO signs off on a retention payment and forgets to tell you.
Here's the same chart as above, but this time the AP manager at your biggest customer went on vacation for two weeks… and you just didn't get paid:
Now there is a new layer, making that intra-month volatility bite much harder and longer.
The problem with spray is that you never know exactly when or where it will hit. But you know something will. It can work in your favor, too: a customer paying early, a supplier accepting a delay. But if it's unreliable in both directions, it offers you nothing you can plan around. So you have to plan for the potential downside but can’t bank on the upside.
What you can do is size it. Understand historically how much spray your business generates, in which direction, and at what frequency. That becomes part of your funding buffer, not a surprise, just a known unknown with a rough price tag.
The Shock Event (The Surge)
By now, we've built all the layers of the regular working capital cycle on top of each other. You can see how the true working capital needs accumulate. And then, once in a while, there is a shock event.
It could be intrinsic; a major customer goes bust, taking their outstanding balance with them. A key supplier pulls their 90-day credit line and demands 30-day terms with immediate effect. Or it could be extrinsic; a knock-on effect of a global supply chain shock like the one we're living through right now, or - God forbid - another pandemic.
A shock event is not the same as a strategic choice to build working capital (say, ahead of a big launch). A shock event is something that happens to you, with a timing you do not control.
Forecasting Working Capital (Why is it so hard?)
Forecasting working capital precisely is difficult for exactly the same reasons it's difficult to forecast the high water mark of the ocean. Cycles on top of cycles on top of cycles.
But we don’t need to forecast it precisely. We need to the forecast the shape correctly, and be in a position to react to the outlying moments. In fact, it’s only when you don’t fund to the true working capital requirement that being precise matters. If you build you house to close to the sea, all of a sudden the precise height of every wave matters.
So, how should you think about working capital forecasting?
For short-term cashflow forecasting, you don't need to forecast working capital explicitly at all. The 13-week cashflow model I've written about before relies on detailed scheduling of cash receipts and payments (rather than working cap itself.)
Forecasting the underlying shape of working capital through is critical for longer-term forecasting; 18-month rolling indirect forecasts, long-range planning, M&A. Here, working capital forecasts reveal funding needs and capital structure shifts that aren’t always intuitive, so the modeling and detail are important.
Here are three failure modes I see constantly:
Failure to recognize the shapes. Most businesses have more than one working capital profile sitting inside them. A core year-round business with a seasonal overlay on top. An export business with a completely different cycle from the domestic operation. Forecast them as one shapeless blob, and you get a forecast that is practically useless. Identify the personalities separately, forecast them separately, and then combine.
Spray distraction. At the other extreme are finance teams that try to forecast working capital to the nth degree. This is like trying to forecast the exact height of ocean spray. It doesn't matter whether a major receivable lands on the 31st or the 1st. What matters is being clear on what is assumed, so you can bridge back when reality differs. Spend your calories on the shape, not the precision.
Spray in the base. The most common error. You're in the last mile of a strategic planning process, and working capital is as an afterthought (again). So you do the easiest thing, take the last hard close actual working capital positions, and layer some assumptions for the movement on top. But what if that base actually includes operational noise? Or a wider-than-usual seasonal swing? The base is already dislocated before you've made a single other assumption. Everything built on top of it is wrong from the start. That's why building from first principles, around a sensible peg, matters so much.
So, how to put this altogether?
First, forecast your core working capital using the end-of-month numbers and their seasonal pattern relative to the peg.
On top of that, calculate a volatility allowance for intra-month swings. This is not a rainy day fund. It is the capital you must set aside to fund the real working capital needs across the month, not represented by your month-end working capital assumptions.
That number was $50M in my last business. We had managed to bring it down from $80M over time, effectively releasing $30M of trapped capital (more on how in week 5). But the $50M was real and stubborn, and once we’d optimized it, we learned to plan for it explicitly.
Then, separately, make sure you have a funding plan for when a surge comes. That shouldn’t sit in your forecasts, but you do need to know how you’ll fund it when it comes (more in week 4 again).
Here is a way of visualizing that:
Homework
Find your peg. Start with your last twelve months of working capital, adjusted for one-offs and noise. That's your reference point. Then ask: which direction is it moving, and why? Will you need more working capital or less as the business evolves?
Define your tidal shapes. How many distinct seasonal cycles sit inside your working capital? What drives each one? When is the peak requirement, and how big is the swing from trough to peak?
Map your monthly wave pattern. Is your operating cycle monthly or quarterly? Where is your intra-month trough — not your month-end position, your real worst day? And is there any low-hanging fruit in rescheduling payments to smooth it out?
Size your spray. How frequently do you get short-term operational shocks, and how big do they run? Can you quantify the capital that needs to be held in reserve to fund the real operating cycle (waves and spray combined) rather than just the month-end position? How do you fund that?
Know your surge limit. How large a shock event could your working capital structure absorb before it became a serious problem? Do you have a number? Do you have a plan?
Net Net
To drive working capital, you need to understand how it actually moves through your business. The broad shapes to plan and forecast around. The volatility to allow for, without trying to predict it precisely.
Peel back the layers, and you get to the true shape of your working capital cycle. And once you can see the shape clearly, you can start to bend it.
That's exactly what we're getting into next week. We’ll cover how some of the greatest growth stories in history were built on turning working capital into a competitive weapon.
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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.
