Balance sheets are easy to understand: on one side, you have assets, which are things that are worth money—property, equipment, inventory, receivables from customers, cash. And on the other side, you have liabilities, which are things that will eventually require money, like accounts payable, debt, or the value of services that you've received cash for but haven't provided yet.¹

That's pretty straightforward, and it gives you a basic model for describing what a business is worth: add up the assets, subtract the liabilities, and you have your answer. As you might imagine, that basic model can only take us so far. Things start to get weird when we try to incorporate a cost of capital: once you recognize that you pay for whatever capital is used to fund the creation of assets (either in equity or debt repayments), the need for assets now becomes a cost, and the ability to undertake low-cost liabilities turns into an asset.

We can illustrate this two ways: first, with a concrete example about the potentially fatal consequences of capital requirements, and a second, more abstract look at the joys of minimizing them.

The first case might be called growing yourself to death. Consider a consumer electronics company with a previously super popular product, like the GoPro (still popular, just less so). Their cash flow cycle probably looks a bit like this:

1. Pay manufacturers to produce GoPros. Let's suppose they have 30 days to pay the manufacturers.

2. Sell the GoPros to customers at a markup via retailers at 50% profit margins.

3. Collect money from the retailers, assuming that they were given 30 days to pay.

4. Repeat.

This is trickiest ahead of the holiday season. GoPro needs enough inventory on hand to sell to all of its customers, but it isn't 100% confident about what they’ll buy. Plus, there's a time lag: GoPro orders the devices, they arrive at a later date, they get sold, and then GoPro is eventually paid by the retailer a month later. So, ahead of the holiday season, our plucky company needs to estimate demand, place some orders, pay for them, and then wait and hope—if Best Buy decides to promote some other category, or if Amazon decides to promote some other brand in the category, they're out of luck.

Let's strap some numbers onto the example. If GoPro thinks they'll do $100m in holiday sales at those 50% profit margins, they’ll order $50m of products to be delivered in, say, September; and if all goes well, they'll start collecting that $100m from retailers in late December (30 days after the holiday shopping season begins in earnest after Thanksgiving). In other words, GoPro temporarily needs $50m in capital in September, for cash flows they expect in January.

Let's assume all goes well! Like many seasonal businesses, they don't generate a ton of cash flow outside of the peak selling season, but those five magical weeks in Q4 make the entire effort worthwhile.

And now, when the next holiday season rolls around, their products are still hot—so they estimate that they'll do $200m in sales this time. So they order $100m in inventory. And they wait. But it turns out that this is not their lucky year, and customers aren't ordering much. The inventory is sitting there, taking up warehouse space. And by the end of the year, they've done the same $100m in holiday sales, just like last year, so they've only moved half of their inventory. The other $50m worth of inventory is just sitting there. But now, it's $50m worth of last year's product, so it's hard to sell; they may end up moving that inventory at a loss just to clear out warehouse space for next year.

This isn’t an entirely made up story—it’s pretty much what happened to GoPro during the 2015 holiday season. And it can get worse than that: if anticipated demand is high enough, and a company over-orders but can't move its products, and its business is cash-flow negative for the period after the holidays, sufficiently fast growth can mean that it literally runs out of cash and dies—even though one of the proximate causes of this death is that the product is getting more popular!

The happier version of this story is when a company uses careful inventory management to flip from subpar to superior returns on investment. Call it shrinking into excellence.

Let's imagine a business that has $6m in fixed assets (property, equipment, etc.), typically keeps $2m in inventory on hand and, at any given time, and is owed about $2m by customers who have received products but not paid for them just yet. And let's also suppose that it typically owes suppliers a similar $2m sum for the goods they've shipped but that haven't been paid for just yet.

If the business does $5m in annual sales, and earns a 16% profit margin, then it's making $800k/year with a 10% return on equity. (That’s $800k divided by $10m in assets minus $2m in liabilities = $800k/$8m = 10%.)

That return on equity is okay, but it’s not too exciting. Fortunately, there's room to improve it. For example, suppose our business unilaterally announces to retailers that it's going to collect the money they owe it twice as fast, and also tells manufacturers that it's going to double the time it expects to pay them. And let's further imagine that this company starts aggressively managing its inventory, always measuring what it has on-hand, only ordering new products when they're absolutely needed, such that it halves the inventory it needs. We can walk through the impact:

• $6m in fixed assets doesn’t change.

• $2m in inventory becomes $1m because the company has gotten much more efficient.

• $2m in accounts receivable becomes $1m, because they're collecting twice as fast, so there's half the balance outstanding at any given moment.

• $2m in payables becomes $4m because they're paying at half speed.

Now, our business's capital requirement has made a dramatic shift; it has reduced its assets from $10m to $8m, and expanded its liabilities from $2m to $4m—so its equity shrunk from $8m to $4m, while achieving the same level of profitability—so now it’s earning a 20% return on equity. Nice!

Meanwhile, reducing cash needs means producing cash; so a business that goes through this shift adds another $4m in cash to its balance sheet. An acquirer who bought the company for $10m and borrowed $6m of the purchase price could, through working capital optimization, get $4m in capital freed up—meaning that their net cash outlay to buy the business is, ignoring taxes, zero.

This is an extreme example, but companies move in this direction fairly frequently: they ask suppliers to wait a little longer for money, they collect it a little faster from customers, and they go over their inventory needs to figure out what's a real "need" and what's a nice-to-have buffer.

We see these effects in our home lives too: consider washing dishes. If you start with a policy of letting things pile up in the sink until the sink is full, then moving them to the dishwasher, and only running it when it is full, etc., many of your dishes will spend most of their time unavailable. Washing everything as soon as possible is basically a magic spell that increases the number of plates, bowls, knives etc. that you can use at any given time without requiring you to buy any more of them.

And if you think it’s hard to execute with dishes, it should be easy to imagine a similar struggle in the world of business. Here, a company trying to optimize inventory needs more visibility up and down the supply chain: it needs to know which suppliers will be available when, which ones are more sensitive to cash needs, and which are more sensitive to price, etc. And managing inventory means keeping a closer eye on demand, too; the more you know about what your customers will be doing in the near future, the more you know what you need to be doing right now.

So just-in-time inventory management and working capital management forces a company to be keenly aware of exactly how it fits into its industry, and into the economy overall. It's a form of corporate introspection and self-awareness, and a profitable one, too.

1. Why is this a liability? Because accrual accounting generally asks you to recognize revenue and costs when they're incurred. If The Diff sells a one-year subscription for $220, that's not an instantaneous one-year profit; a strict accounting would say that the newsletter has sold roughly 150 paid issues at that price, and that each issue generates $1.47 in revenue. But $220 has appeared on the cash line of the balance sheet! We balance this out by creating an offsetting $220 liability, usually labeled "Deferred Revenue," and then reducing that liability by $1.47 with each issue sent. After 150 paid issues, the liability associated with that purchase is $0, and balance is restored: $220 has been paid, and $220 worth of goods and services have been rendered.

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Read More in The Diff

The Diff has covered some great moments in working capital management:

• The auto industry is famous for attempts to do this well ($), and the Toyota Production System was the earliest formalization of these principles.

• Acquisitive conglomerates like Danaher ($) also aim to control working capital: the more cash they free up, the cheaper their acquisitions are in retrospect.

And later this week, The Diff will cover a case where this kind of management went very, very badly, turning a promising acquisition backed by sophisticated investors into a business that hasn't produced net returns for investors over a decade in which competitors did just fine. You can subscribe today to read it.

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