Working Capital

Key takeaways

Net Working Capital = Current Assets (excluding cash) − Current Liabilities (excluding short-term debt). Operationally: AR + Inventory − AP.
Modelled via days outstanding: DSO × Revenue / 365, DIO × COGS / 365, DPO × COGS / 365.
An increase in working capital is a use of cash; a decrease is a source. The signs on the cash flow statement are non-intuitive — get one wrong and the balance sheet doesn't balance.
Growing businesses consume working capital (the cost of growth). Negative-working-capital businesses (subscription, prepaid) release cash as they grow — a structural advantage.
In an LBO, working capital efficiency is a real value-creation lever — collecting AR faster, optimising inventory, extending DPO can free meaningful cash without operational changes.

Definition and components

Working capital comes in two flavours:

Gross Working Capital = Current Assets
Net Working Capital = Current Assets − Current Liabilities
Operating WC = (AR + Inventory + Other Current Assets) − (AP + Accrued Expenses)

For modelling purposes, "working capital" usually means operating working capital — excluding cash, short-term investments, and short-term debt. Those are financing items, not operational, and including them confuses the link between operations and cash.

The days-outstanding modelling convention

Working capital lines are typically modelled as a number of days of revenue or COGS:

Line	Driver	Formula
Accounts Receivable	DSO (Days Sales Outstanding)	Revenue × DSO / 365
Inventory	DIO (Days Inventory Outstanding)	COGS × DIO / 365
Accounts Payable	DPO (Days Payable Outstanding)	COGS × DPO / 365

Compute the historical days from the actuals (e.g., DSO = AR / Revenue × 365), check the trend, project forward (often holding the historical average flat unless there's a thesis for change). The cash conversion cycle is DSO + DIO − DPO — the number of days between paying suppliers and collecting from customers. Lower is better.

The cash flow signs — the most common bug

On the cash flow statement, working capital changes adjust net income to cash flow. The signs are non-intuitive because cash flow is from the company's perspective, not the customer's:

Movement	Direction	CF impact	Why
AR up	↑	Subtract (use)	Customers owe you more — you collected less cash than revenue suggests
AR down	↓	Add (source)	You collected old receivables
Inventory up	↑	Subtract (use)	You bought stock that hasn't sold
Inventory down	↓	Add (source)	You sold stock without restocking
AP up	↑	Add (source)	You owe suppliers more — you held onto cash
AP down	↓	Subtract (use)	You paid suppliers down

The general rule: asset increases drain cash; liability increases supply cash. Reverse for decreases. Get one sign wrong on the cash flow statement and the balance sheet refuses to balance — and tracing which one is wrong takes longer than getting it right the first time.

The growth tax

For a growing business, working capital is a use of cash — the cost of growth. As revenue grows, AR scales with it; as COGS grows, inventory scales; AP grows too but typically not enough to offset. The net is a continuous cash outflow into the business operations.

A simple example: a business growing revenue 20% with DSO of 60 days and DPO of 30 days needs to invest meaningfully in working capital each year just to keep operating. That's why high-growth businesses can show positive earnings and negative free cash flow — working capital is consuming the earnings.

Negative working capital — the structural moat

Some businesses run with negative working capital — customers pay before delivery (subscription, SaaS, prepaid services, gift cards) or suppliers extend long credit terms. As these businesses grow, working capital releases cash:

SaaS with annual prepaid contracts — deferred revenue (a liability) grows with bookings; cash arrives 12 months ahead of recognised revenue.
Walmart-style retailers with low DSO (consumer pays in cash), short DIO (high turns), and long DPO (extended supplier credit) — net working capital can be negative, growth funds itself.
Insurance — premiums collected before claims; the float is a structural cash advantage.

Negative working capital is one of the most undervalued business-quality signals. Pair it with a high return on capital and the math is unstoppable.

Working capital in an LBO

Operational improvement to working capital is a real source of value creation in PE deals — and unlike multiple expansion, it's controllable:

Tighten DSO — invoice faster, automate collections, pursue late payers more aggressively. 5 days off DSO can release 1.4% of revenue in cash.
Optimise inventory — ABC analysis, demand forecasting, JIT principles. 10 days off DIO can release 2–4% of revenue in cash.
Extend DPO — renegotiate supplier terms, consolidate vendors. Less goodwill-friendly than the asset-side levers.

A typical LBO operational thesis includes a working-capital improvement plan with explicit days targets. Tracked monthly, reported to the IC quarterly.

Common working capital errors

Sign errors on the cash flow statement. The most common bug — see the table above. Always cross-check that the balance sheet balances after every adjustment.
Forgetting deferred revenue / prepaid expenses. Subscription businesses have material deferred revenue. Modelling AR/Inventory/AP only misses a major working capital component.
Wrong driver for AP and Inventory. Both should scale with COGS, not Revenue. Common mistake: AP = Revenue × DPO / 365.
Including cash in working capital. Cash is a financing line, not operational. Including it conflates ops with treasury decisions.
Hardcoded WC in projections. If you change revenue and AR doesn't update, the model is decorative.

How Smalt AI builds it

Smalt AI's three-statement and DCF models include a dedicated Working Capital tab that holds DSO, DIO, DPO, and other operational ratio inputs. AR, Inventory, and AP project from those days driven by Revenue (for AR) and COGS (for Inventory and AP). The cash flow statement then computes WC deltas with the correct signs (asset increase → use, liability increase → source). The balance sheet balance check verifies the sign convention before delivery — any sign error is caught at build time.