The cash flow issue is obvious - we all know that we need cash to run a company. But what exactly is working capital and why does it matter?
Let’s start with the definition: working capital is the capital required to run a company day-to-day.
This begs two questions:
- Don’t you also need cash to run your company day-to-day? Yes, you do.
- If so, how is working capital different from cash? We discuss this further in this article and the corresponding video.
For an early-stage startup, working capital can arise in the following three situations:
Situation #1: You extend credit to your customers.
If you sell your products or services on credit, you don’t collect money at the time when the sale occurs. Instead, you generate Accounts Receivable which is the Balance Sheet account that records how much money your customers owe you.
Accounts Receivable are not cash and can’t be used to fund your operations. Therefore, Accounts Receivable increase your funding needs.
Situation #2: You have to make products before you can sell them.
If you have a physical product, you need to manufacture it before you can sell it. This means that you have to spend cash before you can make cash.
Inventory is the Balance Sheet account that records the value of all the unsold products. Inventory is not cash and thus it also increases your funding needs.
Just-in-time manufacturing is so popular because it reduces the time between spending cash to make the product and getting cash from selling that product, thus also reducing the company’s cash needs.
Situation #3: You have credit from your suppliers or/and vendors.
Finally, in some situations you can obtain credit from some of your vendors or suppliers and pay some of your bills later. This generates Accounts Payable, a Balance Sheet account that records how much money you owe.
Accounts Payable are not cash, but unlike Accounts Receivable and Inventory, they decrease your funding needs.
Any of those situations generate working capital, which you need to consider when determining how much cash, or liquidity, you need to run your business. To learn more about working capital and other accounting concepts, check out our Course # 1.
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