Working Capital Management Problems Are Like Onions

Any study of failed businesses would include a large section about working capital management problems. They are like onions – you have to peel off layers to get at the core of the issue.

The Basics of Working Capital

The textbook definition of working capital, or more precisely Net Working Capital (NWC) is: “short-term assets minus short-term liabilities.” In other words, cash on hand plus assets that can be converted into cash in less than a year, minus liabilities coming due during that period. 

NWC = (Cash/Cash Equivalents + Accounts Receivable + Inventory + prepaid expenses) –
(Accounts Payable + Accrued Expenses +Debt Service due over the next 12 months)


Look closely and you will see that NWC summarizes a company’s ability to generate sufficient cash to pay suppliers of raw materials and service its debt over the next 12 months. It gets at the heart of a firm’s ability to continue making and selling products and/or delivering services to its customers.

Working Capital Red Flags

How do we recognize that a company has a working capital problem, not inadequate sales or a bloated cost structure, etc.? The red flag is usually a substantial discrepancy between cash flow from operations and net income. A business owner who says, “We’re generating sales and net income is positive, but we barely have enough cash to pay our bills” almost certainly has a problem with NWC.


The change in NWC is a key component of free cash flow for a given period. If the change is relatively large and positive, it is a warning sign, typically indicating that too much cash is tied up in accounts receivable, inventory, or both (note that a fast-growing business might have receivables that are growing rapidly; a “good” reason for a positive change in NWC).

Common Causes of Working Capital Management Problems

Undisciplined Accounts Receivable collection

Probably the most common NWC problem is that the firm simply does not devote sufficient time and resources to pursuing payment from its customers. Your firm could be generating strong sales but if you are not collecting receivables, you will run out of cash. A company needs someone who “owns” the responsibility of managing A/R, and who provides an A/R analysis to the CFO and CEO on a regular basis, to ensure visibility. That analysis should include a monthly A/R Aging Schedule as well as the A/R Turnover Ratio: Credit Sales ¸ Average Accounts Receivable (measured over a month or two). This individual’s compensation (often a bonus) should partly depend on meeting specific, relevant A/R targets. Firms should also have an in-house “enforcer”, which could be the same individual, who follows up on collections.


If a meaningful percentage of receivables are unacceptably overdue, the firm’s credit terms may be too liberal; applying a penalty on unpaid balances should be considered. If write-offs are high, the firm is likely extending credit to customers who are not creditworthy. This is not uncommon when a firm lacks specific, objective criteria for offering credit instead of requiring upfront payment. This is especially important in the COVID economy when so many firms are struggling. Note that large companies may specify “net 90 days” to pay invoices, which may not be workable for a small supplier. High margin businesses can grant more liberal terms than low margin businesses, and if a firm’s cost of capital is low and margins are high, drawing on a line of credit while waiting for payment may be acceptable, especially given today’s ultra-low rate environment, but this probably would not be feasible for firms with low margins or companies that are under-capitalized.

Poor inventory management

Raw materials and finished but unsold products that sit on a warehouse shelf represent potential cash that is locked up. Manufacturers may buy more raw materials than they need, to qualify for discounts or to meet a minimum order size, but buying and producing more than is needed to meet customer demand over a fairly short period means those materials and products sit for months (or forever); the money spent on them is gone and their cash-generating potential fades away. Inventory buildup also happens when a firm has problems forecasting demand, both micro- and macro-level. Analyze and track patterns in Inventory Turnover: Net Sales ¸ Average Inventory at the Selling Price for both raw materials used and finished inventory.

Other potential causes of NWC problems include:

  • Quality issues – if a meaningful percentage of sales are returned because of quality issues that cannot be fixed, or discounts are frequently given to placate disgruntled customers, the firm should examine its quality assurance processes.
  • Paying vendors too quickly – buying raw materials, etc. on credit allows a firm to hold onto its cash for a month or so. Without abusing the privilege, take advantage of it. 
  • Service business payment model – Many service businesses, including software (SaaS) firms, experience NWC problems because they are not timely with billing and do not collect their receivables efficiently (see above). A service business may need to charge a retainer or require some payment upfront, unless it has a large number of clients, none of whom represent a significant portion of total revenues.

The cash flow statement tells you where to look first. If A/R is the source, drill down to the customer level see which ones are past due. Sort them by dollar amount and look for an 80/20 rule to help focus your collection efforts. If most of your small customers are 60-90 days late, relying on small customers may not be a viable strategy. Conversely, you might tolerate a late-paying customer that is profitable, based on a robust definition of customer profitability. If inventory is the source, looking at inventory turnover per SKU, for both raw materials and finished goods, can produce great insights – we helped a firm to reduce its inventory by more than 50% this way.

Working Capital And Potential Investors Or Buyers

How does NWC impact a firm’s value in the eyes of potential investors or buyers? The present value of any business is based on its ability to generate future cash flows, so investors and buyers analyze how changes in NWC affect cash flow. Private equity investors are particularly interested in how much cash they might have to inject into a business when assessing a buyout. Buyers prefer to acquire firms whose ongoing cash outlays generate quick returns of even more cash. They will carefully evaluate accounts receivable, inventory, and accounts payable turnover to calculate a “cash conversion cycle,” and will assess average monthly NWC over time, analyzing any seasonal patterns.


Companies are typically acquired on a cash-free, debt-free basis, with sufficient working capital. Buyers expect a targeted amount of NWC to be delivered at closing, often defined as “average NWC for the latest twelve-month period,” or as “90 days of networking capital.” In determining NWC, sellers do not receive full credit for past-due receivables, or for obsolete inventory. Overdue accounts payable may be included as debt to be paid off at closing, while various accounting issues affect how deferred revenues, deferred taxes, and sales and use taxes impact how NWC is calculated. Missing the targeted amount of NWC at closing usually results in a dollar-for-dollar adjustment of the purchase price. The bottom line is that sellers should expect buyers to take the most conservative position favorable to the buyer. 

The good news: working capital management problems are generally fixable, if you know how to analyze and tackle the problem. Feel free to reach out to us for help. 

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