The most dangerous lie in business: profitability equals cash.
A £15M SME posts 12% net profit (£1.8M). The P&L looks healthy. The balance sheet tells a different story: £800K in the bank, £2.4M in receivables (90+ days), £1.6M in inventory, and £1.2M in payables due next month.
This business isn't profitable. It's insolvent.
Research from the British Business Bank reveals that 50,000 UK SMEs fail annually despite being profitable on paper. The culprit: working capital mismanagement.
Understanding the Working Capital Cycle
Working capital is the lifeblood of operations: Current Assets minus Current Liabilities. For SMEs, this typically means:
Current Assets:- Cash in bank- Accounts receivable (customer debts)- Inventory (raw materials, WIP, finished goods)
Current Liabilities:- Accounts payable (supplier debts)- Short-term loans- Accrued expenses (wages, taxes)
The gap between these determines whether you can operate tomorrow.
The mathematical reality:
A £20M revenue business with:- 60-day customer payment terms = £3.3M tied up in receivables- 30-day inventory turnover = £1.6M tied up in stock- 45-day supplier payment terms = £2.5M liability
Working capital requirement: £2.4M just to stand still.
Most SMEs discover this when growth accelerates. Each new sale requires upfront investment in materials and labor, but payment comes 60-90 days later. Growth doesn't generate cash; it consumes it.
The Five Working Capital Killers
Killer 1: Payment Terms Mismatch
You pay suppliers in 30 days. Customers pay you in 90 days. That 60-day gap must be funded from somewhere—usually from cash reserves that don't exist.
Example:£500K monthly revenue, 90-day customer terms = £1.5M outstanding£300K monthly COGS, 30-day supplier terms = £300K payableGap: £1.2M you must finance
Small businesses with longer cash conversion cycles experience 40% higher financial distress risk compared to those with optimized cycles.
Killer 2: Inventory Bloat
Manufacturing SMEs hold 90-120 days of inventory "just in case." That's 3-4 months of cash locked in warehouses.
The cost:£2M in inventory10% cost of capitalAnnual cost: £200K just to store products
Plus: obsolescence risk, storage costs, insurance, and opportunity cost.
Killer 3: Poor Collections Process
Invoices sent late. Follow-ups inconsistent. Disputes unresolved. The result: receivables age beyond terms.
Typical SME aging schedule:- Current (0-30 days): 40%- 31-60 days: 30%- 61-90 days: 20%- 90+ days: 10%
That 10% over 90 days? Half is uncollectible. On £3M receivables, that's £150K written off annually.
Killer 4: Seasonal Revenue with Fixed Costs
Retail, construction, professional services—many SMEs have lumpy revenue but consistent expenses.
Q4 generates 45% of annual revenue. Q1 generates 15%. But payroll, rent, and overheads are constant.
The pattern:- Q4: Cash builds- Q1-Q3: Cash depletes- Q4: Scramble to rebuild reserves
Without credit facilities or reserves, Q2-Q3 become existential threats.
Killer 5: Growth Without Capital Planning
Most lethal: winning a major contract that requires upfront investment exceeding available capital.
The scenario:£2M contract won, 60-day payment terms£1.2M materials required upfront£400K labor over 45 daysCash available: £800K
Shortfall: £800K
You've won business you can't afford to deliver. Accept the contract and risk insolvency. Decline it and forgo growth.
The Working Capital Optimization Framework
Phase 1: Measure Current Position (Week 1)
Calculate your Cash Conversion Cycle (CCC):
CCC = Days Inventory Outstanding + Days Sales Outstanding - Days Payable Outstanding
Example:- DIO: 45 days (inventory turnover)- DSO: 65 days (customer payment)- DPO: 30 days (supplier payment)-CCC: 80 days
Industry benchmarks:- Retail: 30-45 days- Manufacturing: 60-90 days- Services: 45-60 days
If your CCC exceeds benchmark by 20%+, you have material inefficiency costing cash.
Phase 2: Accelerate Collections (Weeks 2-8)
Tactical interventions:
Invoice ImmediatelyMost SMEs invoice 5-10 days after delivery. Each day of delay adds a day to DSO.Target: Same-day invoicing (automated)
Payment Terms on ContractsDon't accept 90-day terms by default. Negotiate:- 50% deposit for new customers- Net 30 for established relationships- 2% discount for net 10 (early payment incentive)
Systematic Follow-Up- Day 20: Friendly reminder- Day 35: Formal notice- Day 45: Escalation to management- Day 60: Collections agency
Dispute Resolution80% of payment delays stem from disputes (incorrect quantities, pricing errors, delivery issues).Assign ownership: resolve disputes within 48 hours or they become write-offs.
Phase 3: Optimize Inventory (Weeks 4-12)
ABC Analysis
Categorize inventory:- A items (20% of SKUs, 80% of value): Tight control, optimize turnover- B items (30% of SKUs, 15% of value): Moderate control- C items (50% of SKUs, 5% of value): Minimal stock, order on demand
Just-In-Time Principles
Manufacturing SMEs carrying 120 days inventory can reduce to 45-60 days through:- Vendor-managed inventory (suppliers hold stock)- Drop-shipping (ship direct from supplier to customer)- Economic order quantity optimization
Each 30-day reduction in inventory = 8% of annual inventory value returned to cash.
Phase 4: Extend Payables (Strategically) (Weeks 8-16)
Don't just pay late—that destroys supplier relationships. Negotiate better terms:
Volume DiscountsConsolidate suppliers. Larger orders = better terms."We'll commit to £500K annually if you offer net 60 instead of net 30."
Early Payment Discounts (When They Work)If supplier offers 2% discount for net 10, and you have cash:2% for 20-day acceleration = 36% annualized return(Take it if cheaper than your cost of capital)
Consignment ArrangementsFor high-value inventory, negotiate consignment: you only pay when you sell or use.
Phase 5: Build Credit Facilities (Months 3-6)
Relying on cash reserves alone limits growth. Establish credit before you need it:
Invoice FinancingBorrow against receivables (70-90% advance rate)Cost: 1-3% monthlyBest for: High-quality receivables, strong growth
Inventory FinancingBorrow against inventory (50-70% advance rate)Cost: 8-12% annuallyBest for: Predictable turnover, stable demand
Revolving Credit FacilityTraditional bank line, based on assetsCost: 5-8% annuallyBest for: Established businesses, seasonal needs
Trade Credit InsuranceInsure receivables against non-paymentCost: 0.3-1% of turnoverBenefit: Unlock invoice financing at better rates
Phase 6: Scenario Planning (Ongoing)
Model working capital requirements under different scenarios:
Scenario 1: Baseline Growth (10% annually)Working capital needs: +£X
Scenario 2: Accelerated Growth (30% annually)Working capital needs: +£Y (often 2-3x baseline)
Scenario 3: Major Customer Loss (20% revenue drop)Working capital released: -£Z (but can you survive the shock?)
Update quarterly. Growth consumes cash faster than most SMEs anticipate.
The Quick Wins (Implement This Month)
1.Invoice on delivery (not next week): Saves 5-7 days DSO = £X cash2.Collections call at day 30 (not day 60): Reduces aging by 15-20%3.Renegotiate top 5 customer payment terms: 15-day improvement = £Y cash4.Review inventory turnover: Eliminate bottom 20% slow-movers = £Z cash5.Consolidate suppliers: Negotiate extended terms on volume = £A cash
Combined impact: 20-30 day CCC improvement = 8-15% of revenue returned to working capital.
For a £15M business: £1.2M-£2.2M cash unlocked.
When to Raise External Capital
Sometimes operational improvements aren't enough. Indicators you need external capital:
- CCC >90 days with no path to <60 days- Growth opportunities requiring upfront investment >50% of cash reserves- Seasonal cash needs exceeding 6-month runway- Major contract won requiring working capital injection
Options:-Growth capital equity: 10-30% dilution for £500K-£5M-Revenue-based financing: Repay as % of monthly revenue-Asset-based lending: Borrow against AR/inventory-Private credit: Non-bank term loans
Cost: 8-20% annually (depending on risk/structure)
The Working Capital Discipline
Profitable SMEs fail because they confuse P&L success with cash sustainability.
The discipline required:- Measure CCC monthly (not quarterly)- Forecast cash 13 weeks forward (rolling basis)- Treat working capital efficiency as seriously as revenue growth- Establish credit facilities before growth accelerates- Model working capital needs for every growth scenario
Research shows: businesses reducing CCC by 20% increase enterprise value by 15-25% due to improved cash generation and reduced financing risk.
The uncomfortable truth: Your P&L might be brilliant. If your working capital management isn't, you're building on sand.
Fix the balance sheet, and the income statement takes care of itself.