Profit and cash part company in working capital. A business that grows sales on credit, builds inventory ahead of a season or pays its suppliers faster than it collects from customers can report healthy profits while its bank balance falls. Forecasts that treat working capital as a single balancing line tend to discover this late.
Forecast it from drivers
Working capital is best forecast from the operational drivers that produce it rather than as a percentage of revenue:
- Receivables from sales and the time customers take to pay, expressed as days sales outstanding.
- Inventory from cost of sales and the time stock is held, expressed as days inventory outstanding, or from a production and purchasing plan where inventory is material.
- Payables from purchases and the time taken to pay suppliers, expressed as days payable outstanding.
Driven this way, each balance responds to the things that actually change it. A shift in sales mix towards slower-paying customers, a decision to hold more stock to protect service levels, or a supplier moving to shorter terms all appear in the forecast as cash effects, with a named cause.
Respect seasonality
Annual averages hide the months that matter. A business that builds stock for a peak season needs the cash before the sales arrive, and a forecast built on average days will understate the peak funding requirement. Where activity is seasonal, working capital should be forecast month by month, and the forecast should show the lowest point of the cash balance, not just the year-end position.
Test the assumptions against history
Days outstanding are easy to type and easy to get wrong. Before accepting them, compare each with the recent actuals and ask what would have to change for the forecast to be achieved. If the forecast assumes customers will pay ten days faster than they have for the past two years, someone should be able to say why — a new collections process, a change in terms, a different customer base. If nobody can, the forecast is a hope.
Watch for the model hiding the problem
Two modelling errors commonly conceal working capital pressure:
- Balancing to cash. A model that makes the balance sheet balance by adjusting cash will absorb any error in working capital into the cash line, where it looks like real money.
- Forecasting the cash flow statement directly. The cash flow statement should be derived from the movements in the balance sheet. Forecast independently, it can show cash that the balance sheet does not support.
A three-statement model in which the cash flow is calculated from balance sheet movements, and in which cash reconciles to the change in the bank balance, makes these errors visible.
What to report
The useful working capital figures for management are few: the change in working capital in the period and its main drivers, the days outstanding for each component against target and history, and the forecast low point of cash with the date it falls on. Presented together, they turn working capital from a residual into a lever — one that operations, sales and procurement can each see they control.