The 12-Week MBA Chapter 7: Cash Flow and Working Capital Part 1 - Why Growing Companies Go Broke

What if I told you that the fastest way for a profitable company to go bankrupt is to grow really fast? Sounds backwards, right? That is exactly what this chapter is about.

This is post 9 in my 12-Week MBA retelling series.

The Setup: A Profitable Company on Paper

The authors walk through an example that starts simple and gets scary. Imagine a new company that just finished its first quarter. The P&L looks decent: $10,000 in sales, $6,000 in cost of sales, $3,000 in overhead (sales/admin and R&D expenses), $200 in depreciation. After everything, the net profit is $800. An 8 percent margin. Not bad for a first quarter.

But here is the important context. This company has two contracts that change everything:

• Customers get 90 days to pay (called net 90 payment terms)
• Suppliers must be paid within 30 days (net 30 terms)

Read those two lines again. Customers have three months to pay the company. The company has one month to pay its suppliers. That gap is where the trouble starts.

Walking Through the Math

The authors do something clever here. They start with the assumption that net profit equals operating cash flow, and then systematically show why that is wrong. Let me walk you through it.

First correction: depreciation. The P&L shows $200 of depreciation expense. But depreciation is not a cash payment. Nobody writes a check to “depreciation.” It is an accounting entry to reflect that equipment wears out over time. So the real cash flow is actually $200 higher than the profit number. Not bad, that helps.

Second correction: customers have not paid yet. This is the big one. The company recorded $10,000 in sales according to accrual accounting rules. Products were delivered, so the sale counts. But with 90-day payment terms, not a single dollar has actually arrived from customers. Zero. Every customer payment from this quarter will not show up until next quarter. So cash flow is suddenly $10,000 worse than what the profit number suggests.

That alone takes us from $800 profit to negative $9,000 in operating cash flow. One adjustment and we went from looking healthy to looking like we are drowning.

Third correction: we have not paid all our suppliers yet either. This one helps a little. The company owes suppliers $6,000 for the quarter, but with net 30 terms, some of those payments can be pushed to next quarter. The math works out to about $4,000 actually paid this quarter instead of $6,000. That gives us back $2,000.

Fourth correction: extra inventory. The company bought $1,000 worth of materials that it did not use in any products sold this quarter. On the P&L, this invisible. Unsold inventory does not appear as an expense. But the cash still left the bank account. So that is another $1,000 drain.

The Final Score

After all the adjustments, the company earned $800 in profit but had negative $8,000 in operating cash flow. Let that sink in. The P&L says everything is fine. The bank account says the company is bleeding money.

If this company started with $10,000 in cash, it would be down to $2,000 after one quarter. Another quarter like this and the lights go off. Despite being profitable. Despite customers wanting the product. Despite growing.

Growth Makes It Worse, Not Better

Here is where it gets really painful. You might think the cash flow problem is just a first-quarter startup issue. Once the business gets going, customer payments from last quarter will start flowing in. Problem solved, right?

Wrong. And this is the key insight of the chapter.

Suppose sales grow 50 percent in Q2, going from $10,000 to $15,000. Great news for the P&L. Profit jumps to $2,800. But look at the cash side. In Q2, the company finally collects $10,000 from Q1 customers. But it is now deferring $15,000 in new customer payments to Q3. The gap is getting bigger, not smaller.

As long as the company keeps growing, the money owed by new customers will always exceed the payments coming in from old customers. The faster you grow, the worse this gets. Growth is supposed to create value for shareholders. But in a company where customers pay slowly and suppliers need to be paid quickly, growth can literally kill you.

The authors call this “choking on growth.” Two of the three value drivers, profitability and growth, are firing on all cylinders. But the cash flow dynamics are destroying the company from the inside.

Real Stories of Companies That Almost Died

Lucent Technologies was a massive telecom equipment maker in the late 1990s. They sold fiber-optic cables and network switches to companies building out the internet. Business was booming. They grew fast and offered customers generous payment terms.

Some of those customers were solid companies like AT&T. Others were startups chasing the dot-com dream. When the economy stumbled in 2001, many of those startups went under and took their unpaid bills with them. Lucent’s stock went from over $100 per share to less than $1. More than $100 billion in market value vanished. The company eventually got bought out.

Netflix had a different version of the same problem. Back when they mailed DVDs (yes, actual disks in actual envelopes), they offered new customers a three-month free trial. Think about what that means in cash flow terms: a three-month free trial is basically net 90 payment terms. Meanwhile, for every new subscriber, Netflix had to buy three DVDs up front. Cash was flying out the door to buy inventory, and nothing was coming in for three months.

The faster Netflix grew, the bigger the cash hole got. They nearly went broke from their own success. They survived by cutting the free trial to one month and renegotiating deals with film distributors so they paid less up front in exchange for sharing revenue later.

Working Capital: The Name for This Problem

The gap between when customers pay and when suppliers get paid has a formal name: working capital. Specifically, trade working capital.

The formula is simple:

Trade Working Capital = Accounts Receivable + Inventory - Accounts Payable

Accounts receivable is money customers owe you. Inventory is stuff you bought but have not sold yet. Accounts payable is money you owe your suppliers. The difference between what is owed to you (plus what is sitting on your shelves) and what you owe others is your working capital requirement.

In the book’s example, after Q1 the company had $10,000 in accounts receivable, $1,000 in inventory, and $2,000 in accounts payable. That means trade working capital was $9,000. Someone has to fund that gap. Banks, investors, somebody. And every quarter the company grows, that gap grows too.

What Can You Do About It?

The authors suggest three levers for managing working capital.

Negotiate better payment terms. If you could get your supplier terms to match your customer terms (say, net 90 for both), you would defer a lot more of your costs. In the example, accounts payable would jump from $2,000 to $6,000, slashing the working capital gap in half. This has nothing to do with how good your product is. It is pure negotiation.

Reduce inventory. This is the whole philosophy behind lean manufacturing and just-in-time delivery. Every dollar sitting in a warehouse is a dollar not in your bank account. The less stuff you stockpile, the less working capital you need.

Collect from customers faster. If you can shorten payment terms, you close the gap from the other direction. Net 60 instead of net 90 is a meaningful improvement.

The Holy Grail: Negative Working Capital

Some companies flip the whole thing on its head. What if customers pay immediately but suppliers do not get paid for months? Companies like Amazon and Dell have pulled this off.

When you buy something on Amazon, your credit card gets charged right away. But Amazon might not pay its supplier for 60, 90, or even 120 days. Cash flows in fast and flows out slowly. Like a dam on a river, cash pools inside the company.

Michael Dell built his entire company this way. He took credit card orders over the phone and then used long supplier payment terms to assemble computers with what was essentially other people’s money. Dell grew into a multi-billion dollar company in just a few years, partly by making the cash flow dynamics work in his favor instead of against him.

For a growing company, negative working capital creates a virtuous cycle. Growth generates excess cash instead of consuming it. That cash funds more growth. Which generates more cash. And on it goes.

The Hidden Risk of Being Too Lean

But the authors are careful to point out the trade-offs. Cut inventory to zero? Great for cash flow, but what happens when a big order comes in and you cannot fill it? Demand net 0 payment from customers? Your competitor offers net 30 and steals your business. Squeeze your suppliers with 120-day payment terms? They raise their prices, deprioritize your orders, or go broke themselves.

The push for lean inventory management has real-world consequences beyond individual companies. When Covid hit in 2020 and supply chains broke down, companies that had been running with minimal inventory had zero buffer. Car manufacturers ran out of computer chips because they had not kept any in stock. Chip factories in Taiwan shut down temporarily, and car production ground to a halt worldwide. Prices shot up, even for used cars.

The global inflation wave of the early 2020s was partly caused by decades of companies squeezing working capital to the bone. Great for shareholder returns in normal times. But when the system has no slack, even a small disruption cascades everywhere.

Key Takeaway

Profit and cash flow can move in completely opposite directions. A growing, profitable company can bleed cash and go bankrupt if there is a gap between when customers pay and when suppliers need to be paid. The faster you grow, the worse this gets. Working capital management - negotiating payment terms, controlling inventory, collecting faster - is one of the most important and most overlooked levers a business leader has. Some companies like Amazon and Dell turned negative working capital into a competitive weapon. But pushing too hard for efficiency leaves no room for error when the world does something unexpected.

Book: The 12-Week MBA by Nathan Kracklauer & Bjorn Billhardt | ISBN: 978-0-306-83236-9

Previous: Chapter 6 - Cash Flow Basics

Next up: Chapter 7 - Cash Flow and Working Capital Part 2 - Managing the cash gap.

Part of the 12-Week MBA retelling series