Net Working Capital - a reflection of the design and execution of a business model

An organization can improve its financial performance without increasing revenues or lowering costs. With two organizations generating the same revenues and costs, the one that needs the least financial investments will generate the highest return on investments, and have the highest freedom of action. Many interesting and innovative business models implemented by companies such as Dell, Southwest Airlines, Toyota and Zara, have at its core an effective Net Working Capital model. This post is an introductory to the concept and will be followed by a post exploring it further, with examples from different industries.

What is Net Working Capital?

Net Working Capital (NWC) is defined as current assets minus current liabilities and is a financial metric which represents operating liquidity available to a business. It indicates the firm's ability to convert its resources into cash and by quickly turning resources into cash, have the ability to put the cash to use again, ideally to reinvest and make more sales.

Current Assets comprises of cash and cash equivalents, inventory, and accounts receivable. To take a manufacturing company as an example: it needs cash to buy raw material or components (inventory), use the material in production (work-in-process inventory) to produce finished-goods (finished-goods inventory), to sell to customers who might get some days to pay (creating accounts receivables).

Current Liabilities includes accounts payable for goods, services or supplies that were purchased for use in the operation of the business. In the case with the manufacturing company above perhaps it didn't have to pay cash for the raw material or components, but had some creditor days (creating accounts payable).

Net Working Capital can thus be positive or negative depending on when raw material is paid to suppliers, how long the goods are in inventory and when goods are paid by customers.

Positive NWC:

Negative NWC:

Let's assume that the manufacturing company buys raw material and convert it to products which it sells on average after a total of 20 days in inventory, plus providing customers with 20 days to pay, creating total current assets (other than cash) of 40 days.

Scenario 1 - Positive NWC: The manufacturing company needs to pay its suppliers in an average of 30 days. The cash it takes to finance the business is 10 days multiplied by average sales per day.

Scenario 2: Negative NWC: The manufacturing company needs to pay its suppliers in an average of 60 days. The company has 20 days multiplied with the average sales per day in cash surplus, cash that can be used for other things.

Funding growth

If the company in Scenario 1 is growing rapidly, increasing amounts of cash will be needed to pay its suppliers and eventually to hire more people, and the cash from sales will never be able to catch up thus other sources of cash is needed. Failing to find additional sources of cash, profitable companies sometimes go bankrupt. If the company in Scenario 2 is growing rapidly, increasing amounts of cash will be available to fund the growth and other initiatives.

Capital always comes at a price

Different business models require different amounts of working capital depending on things such as the need for different inventory, when customers pay and when suppliers are being paid. Companies with business models that can use cash from customers require less investment and can thus generate higher return on those investments. Companies with business models that need lots of working capital will have to raise it from somewhere and capital always comes at a price.

How much NWC is need?

All components of a business model have an effect on NWC and every organization needs enough cash and inventory to do its job. Reducing inventory too much and the production might be interrupted, push the suppliers too hard and they might run out of cash and perhaps go bankrupt, push the customers too much and they will go to someone else, too much leverage using other organization's assets and you might lose control. Finding the right balance is a challenge and using the business model concept to identify tied up cash can be a very useful exercise.

Using the business model concept

In the next post I will exemplify how the business model concept and business model innovation can have a huge direct effect on Net Working Capital but also have indirect effects such as improved efficiency, quality or customer satisfaction. It will be a "How to" post with questions to ask to find where money is tied up, and money tied up in working capital is money not available to grow the company.

Bob Iger, President and CEO Walt Disney on Digital Business Models

Bob Iger, of Walt Disney, in an interesting interview with Fortune's Richard Siklos.

"When we think about monetization we look at advertising, micropayments, paid-for-content and subscription"

"We believe that anything that serves consumers better is a good thing so consumers who have subscribed to multi-channel services, being able to watch those programs and those channels online, we think is a good thing. We do believe though that it is something that should be charged for."

"You have to have one hand in the future and one hand in the present, if you have two in one place then you fail. If you have two in the future then you are not managing your business day to day and that's a big problem operationally, and if you are just managing today, you will miss out opportunities or you will completely ignore significant threats and not prepare yourself for that, so this notion of protecting the present is something that I talk about a lot at the company"

"The most important thing is what is the consumer doing and where the consumer is going"

"The record industry was propped up by a business model selling a 15 song CD for $15, that wasn't sustainable because the price to value relationship was not there, and the other thing that was really interesting was that consumers knew that they could access music in much more convenient ways online and they ended up getting angry that the retailers or the record industry wasn't providing that experience"

Related videos:

• The Future of Content & Telecoms: Flat Rate Content Bundles and Social Media (Gerd Leonhard @ eComm 2009)
• David Heinemeier Hansson on Charging for Online Services
• Nick Bilton on new technology that will enable interesting business models for news

Getting to Plan B (2009)

The book Getting to Plan B: Breaking through to a better business model, written by John Mullins and Randy Komisar, contains several important lessons, primarily for start-up entrepreneurs, on developing successful business models. Though very repetitive around a few key ideas, the book is well worth reading especially for those who want to better understand how the business model is reflected in the different financial statements. with interesting examples from: Amazon, Apple, Celtel, Costco, Dow Jones & Company, eBay, GlobalGiving, GO airlines, Google, Oberoi Hotels, Pantaloon, Patagonia, Ryanair, Shanda, Silverglide, Skype, Southwest Airlines, Toyota, Walmart, Zara and ZoomSystems.

The book in three bullet points:

• The business model concept is in the book defined as the pattern of economic activity comprising of five key elements that together determines the viability of any business. The five key elements being the revenue model, the gross margin model, the operating model, the working capital model and the investment model. Companies are successful when the five elements work together.

• Getting to Plan B is about the process of discovering a business model that works, with the assumption that the initial plan is most often wrong. The discovering process can be made systematic by constantly formulating different hypothesis and measurements and continuously follow up and iterate the business model into a new Plan B.

• The starting point for a new business model is to learn from successful examples worth mimicking in some way and examples to which you explicitly choose to do things differently, where the ultimate judge is the customers and the cash flow generated from your business model.

A brief summary of the different chapters:

1. Don't reinvent the wheel, make it better - the concepts of analogs (successful predecessors), antilogs (predecessors that you want to differ from), and Leaps of Faith (beliefs about answers with no evidence) is covered with the key take out to learn, mix and match to create your own business model, to experiment to test different hypothesis to prove or refute them.

2. Guiding your flight progress - the concept of dashboarding (a systematic way to guide experiments and track results) is presented with examples showing that measuring of specific parameters or results increases the focus of the company's activities, and that the dashboards, including parameters and goals, need to evolve over time based on the learnings they uncover.

3. Air, food and water - the chapter, focusing on revenue models, hits home two important points: the importance of resolving customer pain or providing customer delight, and the need for actual evidence of how customers are likely to respond. To develop a revenue model questions that need to be asked are: Who will buy? What will they buy? Why will they buy? How soon, how often, and how many will they buy? With what effort and cost on your part? At what price will they buy, and on what basis will they pay?

4. Avoiding rocks and hard places - the topic for the chapter is gross margin models; the spread between the price at which products and services are sold and the cost of selling those (COGS). The key messages with the chapter are that digital technology enables gross margin models in which COGS approaches zero, that a superior gross margin model creates leverage that can be applied differently depending on strategy, and finally the fact that pricing decisions should be value-based and not cost-based.

5. Trimming the fat - is a short chapter on operating costs; all the day-to-day costs that must be incurred in addition to COGS. Key ideas are that by doing things differently in relation to other actors in the industry, operating cost can be lowered or eliminated, and by starting the analysis at the most costly or scarcest resources in the industry areas for business model innovation might occur. Another key point is that adding costs might also enhance the customers' experiences and willingness to pay premium prices, so cost cutting is not always the answer to profitability.

6. Cash is king - is according to me one of the more important chapters in the book as the balance sheet, working capital and cash management is often forgotten in business model discussions. Different industries and business models requires different amount of working capital (the cash a company needs to keep the business running) and all elements in the business model have implications for the cash generated and the cash consumed. From page 139: "Failure to earn a profit won't put you out of business, as long as you still have cash. But if you run out of cash, even if you are profitable, you'll be gone in a heartbeat"

7. It takes money to make money - focus on the investment needed to get the business started and through the period until it can generate enough cash itself, and the general goal (there are exceptions) is to find a way to get to breakeven with as little investment as possible. The authors mention some of the many trade-offs involved with external funding from different sources, but primarily focus on venture capital. The conclusions are: Less investment means giving away less of the business, less credibility lost when leaving a business model for another, and fewer sleepless nights if you've mortgaged your house.

8. Can you balance a one-legged stool? - tries to summarize, at least on a conceptual level, the different elements of the authors' definition of a business model, and their implications on one another. The conclusion is that the revenue model, gross margin model and operating model directly affect the working capital model, and these four models directly affect the investment model.

9. Getting started on discovering your Plan B - ends the book where it started with a focus on the talented and visionary entrepreneur. In the beginning of the book there were statements such as "Intuitively, as is almost always the case for committed, passionate, entrepreneurs, they felt that the answers to all five questions were yes" (p29) and in the end "dreaming your entrepreneurial dream" (p214)...

A quick comparison with some other popular books on business models:

• The Ultimate Competitive Advantage: Secrets of Continually Developing a More Profitable Business Model by Mitchel, Coles, Golisano and Knutson, has a heavier focus on marketing with some ideas and questions relating to one-sided business models, so if you are looking to "sell more" perhaps you like this book. See my review here

• The Profit Zone: How Strategic Business Design Will Lead You to Tomorrow's Profits by Slywotzky, Morrison and Andelman, has a heavier focus on profitability and the changing areas in which high profit is possible to keep, it is a quick read. See my review here

• Open Business Models: How to Thrive in the New Innovation Landscape by Henry Chesbrough has a heavier focus on technological innovation in the context of business models and also covers the important area of Intellectual Property in relation to open business models.

• Business Model Generation: A Handbook for Visionaries, Game Changers, and Challengersby Osterwalder and Pigneur, atempts to introduce a standard language and format for analyzing and innovating business models based on the business model canvas. The book that was co-written with 470 practitioners is a great book to learn about different business models and tools for business model innovation. See my review here

All in all, the book is somewhat repetitive and rather long for the ideas it delivers, but with many interesting examples and important chapters on gross margins, operating costs and cash flow, it is well worth reading and a good complement to other books on business models not going into the financial details.

If you find this book review helpful, please go to the Amazon book review page and rate my identical review "Helpful". Thanks!