More Realism - Working Capital

Chapter 14: About Business Numbers - Page 14.8

More Realism - Working Capital

Even in the case of the Numbers Mount Up illustration below, the example is completely unrealistic.

Numbers Mount Up

You have the same sales and profits as in the earlier Three Widgets Sold example, but the balance sheet is more complex.

Where are the running expenses, such as rent, salaries, telephones, or even advertising those widgets?
How would they affect the cash situation?
How far would we get if we couldn't pay the rent or the telephone bill while waiting for customers to pay us?
Furthermore, what supplier would give us a widget on credit when we have no history and no assets?
What bank would loan us money in this situation? Banks do loan against inventory and receivables, but only to a certain percentage of total value.

What was missing here, all along, was working capital.

Important: In strict accounting terms, working capital is equal to short-term assets minus short-term liabilities. In real terms, however, working capital is the glue that holds your cash flow together. Get it into the bank before you need it, or you won't survive the unexpected.

The Working Capital illustration goes back to the beginning of this whole example and does it right, with enough capital in the beginning to finance the company.

Working Capital

In this illustration the business has enough working capital to survive the unexpected.

Instead of starting with $100 as capital, this business looks a lot better with starting capital of $400. With this additional capital from the start, buying on credit and borrowing against assets is more realistic. In this scenario, working capital is up to $550. Now it has a proper input of working capital at the beginning. With even the barest of business plans, we could tell that $100 wasn't enough to get this business going.

As you can see from the examples, the numbers in a normal business analysis and in a business plan are interrelated. In previous chapters we did the sales forecast and personnel plan, which then reappeared in the income statement, also called the profit and loss. You can see from the examples how the income statement links to the balance sheet. We'll go into cash flow and balance in following chapters, but the point here is that the assumptions and estimates in the standard business plan tables link up to each other in a complex system of relationships. You can see how these relationships work in the next pages.

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