Last year I was having lunch with a friend who excitedly told me about a new contract he had been awarded.
The contract was $1.2 million in revenue at an impressive 40% gross margin and would add significantly to his existing revenue and net income. I congratulated him and encouraged him to tell me more.
I asked him what the payment terms would be with his new customer—billed monthly.
I asked him how often he would need to pay his employees—every 2 weeks.
I then asked, "Do you have $120,000 in your bank account or available on a line of credit?"
"No,” he said. “Why would I need that? I just told you that I'm going to make $480,000 (40% of $1.2 million) over the next year."
"Then you are going bankrupt in the first 45 days of the project."
"Why?" His smile changed.
I explained that if he bills monthly and it takes his first customer 30 days to pay after he submits his bill, he could be waiting up to 60 days for his first check. During those 60 days, he'll need to make three payrolls and the 4th payroll would theoretically hit on the 60th day. So funding the 4th payroll could be a problem as well if he doesn't have time for his check to clear before cash must leave his account to pay his workers.
For simplicity, if we assume that his only cost is labor, then each month my friend would need to pay his workers $60,000 (or $30,000 per bi-monthly payroll). By the end of the third payroll he would have spent $90,000 and still not have received a penny from his customer. In the very likely event that his customer waits the full 30 days he is allowed or even a couple of days late, my friend would have funded four payrolls, or $120,000, without a penny from his customer.
While my friend's story portrays a simple example, hopefully the point is clear. Payment arrangements are often significantly more complex than this, and not forecasting their effects on working capital can be disastrous.
Working capital (which is often confused with operating cash) is the cash that is trapped in your business at any given time. You've earned it, but you can't use it. While adjustments to this definition often need to be made for companies with complex working capital processes, you can find it on your balance sheet by subtracting Current Liabilities from Current Assets. Normally, it should be a positive number, but shouldn't be too high as that could be an indicator that a company is carrying excess inventory or isn't properly investing excess cash.
Profitable companies have literally grown themselves in bankruptcy because they didn't properly forecast and fund their working capital needs as they grew. Any time you prepare for a major new project or begin to experience growth, you should map out your working capital needs by month (or week if necessary) for a time period long enough to capture the pea