Working capital, cash conversion, and earnings quality

Growth can increase revenue, profit, and the chance of insolvency at the same time. The missing variable is how long your cash remains trapped between paying and collecting.

Suppose fictional Kaveri Systems wins twice as many orders next year. Components must be bought before installation. Technicians are paid monthly. Customers pay sixty days after acceptance. Every order makes a gross profit, but every order also asks Kaveri to finance the interval between cash out and cash back.

That interval is the operating cycle. A founder who manages only margin sees half the machine.

The cash tied inside operations

Broad net working capital is:

Net working capital = current assets − current liabilities

For operating decisions, isolate the items driven by trading. A useful simplified view is accounts receivable plus inventory minus accounts payable. Depending on the business, add contract assets, deferred revenue, accrued operating costs, and other operating balances. Keep cash, interest-bearing debt, and non-operating items separate when the purpose is to understand the trading cycle. Working capital is a stock measured on a date. Cash conversion is a time problem. The cash conversion cycle estimates how many days operating cash is committed before it returns:

• Cash conversion cycle = DIO + DSO − DPO • DSO = average accounts receivable ÷ credit revenue × days in period.
• • DIO = average inventory ÷ cost of goods sold × days in period.
• • DPO = average accounts payable ÷ relevant credit purchases or, as an approximation, cost of goods sold × days in period.

Definitions vary across systems. Write yours beside the calculation and compare it consistently over time.

A seventy-three-day funding gap

Kaveri’s fictional Year 2 plan assumes ₹60 lakh revenue, ₹30 lakh cost of goods sold, ₹10 lakh average receivables, ₹5 lakh average inventory, and ₹4 lakh average payables. Using 365 days and cost of goods sold as the payable denominator:

Its simplified operating working capital is ₹11 lakh: ₹10 lakh receivables plus ₹5 lakh inventory minus ₹4 lakh payables. If orders rise abruptly, that requirement may rise before retained profit supplies the cash. The business can therefore be economically profitable and financially strained.

A negative cash conversion cycle can be excellent when customers pay reliably before suppliers are due, as in some subscription, marketplace, or fast-turn retail models. It can also signal distress when payables are overdue because suppliers have stopped extending trust. The sign of the number never replaces its cause.

Pull the levers in the right order

The cleanest working-capital improvements also improve the customer or operating system. Bill correctly and early. Put acceptance criteria, purchase-order requirements, tax documentation, milestone dates, and the invoice recipient into the contract. A perfect sales process that produces a rejected invoice is a financing error.

Collect by design. Use deposits, subscriptions, milestone billing, retainers, or payment on delivery when the value and risk allocation support them. Send reminders before due dates. Escalate disputed invoices to a named owner. Do not call a receivable “cash expected” without a probability and date.

Reduce time in inventory and work-in-progress. Order against evidence, standardise components, shorten setup, expose slow-moving stock, and separate safety stock from forgotten stock. Inventory can protect service levels; excess inventory hides forecast error and obsolescence.

Negotiate supplier terms honestly. Match payment timing to the operating cycle where possible. Consolidated purchasing, dependable forecasts, and a record of paying as agreed can earn better terms. Quietly paying late is not a strategy. It transfers your cash problem to a supplier and spends reputation. Protect contribution. Better collection cannot rescue a product whose price fails to cover delivery, service, returns, and variable acquisition cost. Working capital determines timing; unit economics determines whether cash comes back with a surplus.

Match finance to duration. A short, evidenced receivables gap may suit a properly structured working- capital facility. An uncertain product experiment does not produce a reliable repayment schedule. Chapter 31 supplies the funding gate.

Build the thirteen-week view

A monthly runway number is too blunt near a payment date. Keep a weekly forecast for the next thirteen weeks with:

• • opening available cash, separated from restricted or purpose-bound cash;
• • collections by named customer and invoice, with expected date and confidence;
• • payroll, tax, rent, suppliers, debt service, refunds, and committed purchases;
• • discretionary spend that can be delayed without breaking a promise;
• • minimum cash, facility headroom, covenant dates, and downside cases;
• • closing cash and the specific action required before any breach.

Mark every input Fact, Assumption, or Forecast. Blank means unknown, never zero. Reconcile the prior week’s forecast to actual cash. The variance teaches you whether customers, sales staff, purchasing, or management assumptions deserve less confidence.

Earnings quality is conversion plus explanation

Operating cash flow trailing net income deserves investigation. It can reflect healthy growth that temporarily builds receivables or inventory. It can also reflect weak collection, aggressive revenue recognition, obsolete stock, capitalised costs, or customers that should never have received credit.

Operating cash flow exceeding net income can be healthy, but the relationship is not proof. Depreciation may explain a legitimate gap. Customer advances may finance growth. It may also be boosted temporarily by stretching payables, collecting unusually early, factoring receivables, or cutting necessary inventory. Classification choices and period-end timing can flatter cash reporting. Read the balance-sheet movements, accounting policies, and notes.

Use a compact earnings-quality bridge each month:

1. start with net income; 2. separate genuine non-cash expenses and gains; 3. explain every material receivable, inventory, payable, deferred-revenue, or accrual movement; 4. separate maintenance from growth capital expenditure where supportable; 5. identify financing hidden in operations, including supplier stretch, customer advances, or receivables sales;

6. compare the pattern across several periods and against the operating explanation.

Warning patterns include receivables growing faster than credit sales, repeated old balances with no provision, inventory growing faster than demand, margin improving through unexplained capitalisation, recurring “one-time” adjustments, unexplained policy changes, and profit growth with deteriorating cash conversion. None proves misconduct. Each earns a documented answer and, where material, professional review.

Protect cash without damaging the engine

Do not maximise cash this quarter by breaking next quarter. Collecting every customer in advance may destroy conversion. Eliminating all safety stock may increase downtime. Refusing every supplier’s preferred term may remove the best supplier. The goal is a cycle that customers accept, operations can deliver, and the company can finance under a downside case.

My son, cash pressure narrows judgment. Work on it while you still have choices. By the time payroll depends on one late invoice, every negotiation has become more expensive.

· EF pp. 75–82 · FS pp. 19–27, 52–55 · TABLE pp. 26–29 · GE ch. 25. Mechanisms paraphrased; Kaveri Systems and all planning figures are explicitly fictional.