A distributor with $500m of revenue and a 20% gross margin grows revenue 30%. Days sales outstanding are 60, days inventory 90 and days payable 45. How much cash does the growth consume, and what does the answer say about the business?

A distributor with $500m of revenue and a 20% gross margin grows revenue 30%. Days sales outstanding are 60, days inventory 90 and days payable 45. How much cash does the growth consume, and what does the answer say about the business?

Approach: Express each working capital line as a share of revenue or cost of goods, sum them into a net working capital ratio, then apply that ratio to the incremental revenue and compare with the incremental gross profit.

39.5. The growth consumes $39.5m of cash. Receivables are 500 * 60/365, or $82.2m. Cost of goods is $400m, so inventory is 400 * 90/365, or $98.6m, and payables are 400 * 45/365, or $49.3m. Net working capital is 82.2 + 98.6 - 49.3, which is $131.5m, or 26.3% of revenue. Growing revenue by $150m therefore absorbs 0.263 * 150, which is $39.5m of cash. Incremental gross profit on that revenue is only 0.20 * 150, or $30m, so the growth consumes $9.5m more cash than it produces before a single operating expense is paid. The cash conversion cycle is 60 + 90 - 45, which is 105 days, and a business with a cycle that long and a margin that thin burns cash faster the faster it grows, which is how such firms fail while reporting rising profit.

Follow-up: Days payable are renegotiated from 45 to 75. How much cash does that release, and what is the risk of funding growth that way?

Key concepts: net working capital, cash conversion cycle, growth, gross profit.