The income statement shows what a business earned over a period. The balance sheet shows what it owns and owes on a single day. Read across several years, it reveals how a business actually operates, and whether its profits turn into something solid.
This article looks at the short-term part of the balance sheet, following the approach in Warren Buffett and the Interpretation of Financial Statements: cash, inventory, money owed by customers, money owed to suppliers, and the current ratio. Together these make up what is usually called working capital: the money tied up in running the business day to day. It is one of the most practical areas of finance for anyone running a business, because it is where profits either become cash or quietly disappear.
The shape of the balance sheet
Every balance sheet follows the same basic equation:
Assets = Liabilities + Shareholders’ equity
What the business owns equals what it owes to others plus what belongs to its owners. Both assets and liabilities are split into current items, expected to turn into cash or be paid within about a year, and non-current items, which last longer.
Current assets typically include cash, receivables (money owed by customers), inventory (stock) and prepaid expenses. Current liabilities typically include payables (money owed to suppliers), short-term borrowings, the current portion of long-term debt, tax owed and employee entitlements due soon.
Working capital is current assets minus current liabilities. It represents the cushion, or the gap, between what will turn into cash soon and what must be paid soon.
Cash: how much, and where it came from
A large cash balance is reassuring. Cash lets a business survive a downturn, take opportunities competitors cannot afford and avoid borrowing on bad terms. The book’s rule is that plenty of cash and little or no debt usually means a business can ride out hard times, while little cash and heavy debt usually means it cannot.
But the book adds an important test: find out where the cash came from. Cash can pile up for three very different reasons:
- the business generates it from operations, year after year
- the business borrowed it or sold new shares
- the business sold an asset or a division
Only the first is evidence of strength. The authors suggest reviewing around seven years of balance sheets to see whether cash is accumulating steadily from ordinary trading, or arriving in lumps from financing and asset sales. The cash flow statement, discussed in the next article, shows exactly which of the three sources produced it.
Cash and debt together
Cash should always be read alongside debt. A business with $50 million of cash and $200 million of borrowings is in a very different position from one with $50 million of cash and no borrowings. Net cash (cash minus borrowings) or net debt (borrowings minus cash) is a useful single figure that captures both.
Inventory: it should rise with the business
Inventory is stock waiting to be sold: raw materials, work in progress and finished goods. On its own the number says little, and some businesses, such as many service firms, carry almost none.
For businesses that do carry stock, the book suggests watching whether inventory and earnings rise together. Growing inventory alongside growing profits is consistent with a healthy business expanding. Inventory that swells while profits stall can mean products are not selling, or that the business is stockpiling to hide weaker demand.
Why inventory is risky
Inventory carries several costs that do not appear on the price tag:
- cash tied up that could be used elsewhere
- storage, insurance and handling
- obsolescence, as products go out of fashion, expire or are superseded
- shrinkage, through damage, loss or theft
When inventory grows faster than sales, all of these grow with it. And when demand eventually falls, excess stock usually has to be discounted, cutting margins at the worst possible time.
Days inventory
A useful measure is days inventory outstanding: inventory divided by cost of goods sold, multiplied by 365. It estimates how many days, on average, stock sits before it is sold. Rising days inventory, year after year, is often an early sign of slowing demand or poor stock control.
Receivables: what customers still owe
When a business sells on credit, the unpaid amounts sit on the balance sheet as receivables, reduced by an estimate of what will never be collected (often called an allowance for doubtful debts or expected credit losses).
The book’s insight is comparative. In competitive industries, some companies win sales by offering customers longer to pay, which inflates both sales and receivables. A business that consistently carries lower receivables relative to sales than its competitors usually has some advantage: customers pay promptly because they want the product, not because the terms are generous.
Days sales outstanding
The matching measure is days sales outstanding: receivables divided by revenue, multiplied by 365. It estimates how long customers take, on average, to pay. If a business offers 30-day terms but its days sales outstanding is 55, customers are paying late, and the business is effectively lending them money.
Receivables rising faster than sales is one of the classic warning signs in financial analysis. It can mean customers are struggling to pay, terms are being loosened to win business, or, in the worst cases, that revenue is being recognised before it is genuinely earned.
Payables: what the business owes suppliers
The other side of working capital is payables: money owed to suppliers for goods and services already received.
Payables are a form of free short-term funding. If suppliers allow 45 days to pay and customers pay in 15, the business holds its customers’ money for a month before paying its suppliers. Large retailers with strong bargaining power often operate this way, and it can be a genuine advantage.
Days payables outstanding (payables divided by cost of goods sold, multiplied by 365) measures this. But stretching suppliers too far damages relationships, risks supply and can be a sign of cash stress rather than strength. In Australia, the Payment Times Reporting Scheme requires large businesses to report how quickly they pay their small-business suppliers, reflecting concern about slow payment practices.
The cash conversion cycle
Putting the three measures together gives the cash conversion cycle:
Cash conversion cycle = Days inventory + Days sales outstanding − Days payables outstanding
It estimates how many days pass between paying suppliers and being paid by customers. Here is an illustration for a small wholesaler.
| Measure | Days |
|---|---|
| Days inventory outstanding | 60 |
| plus days sales outstanding | 45 |
| less days payables outstanding | 30 |
| Cash conversion cycle | 75 |
This business funds 75 days of operations from its own cash. If its annual cost of goods sold is $3.65 million (about $10,000 a day), it has roughly $750,000 tied up in working capital. Cutting the cycle by 20 days, through faster stock turnover or quicker collections, would release about $200,000 without a single extra sale.
That is why working capital matters so much for growing businesses. Every increase in sales requires more inventory and more receivables. A business with a long cash conversion cycle can grow itself into a cash crisis while remaining profitable on paper.
The current ratio, and why it can mislead
Traditional analysis divides current assets by current liabilities. A ratio above one is usually treated as safe, because the business has more coming in soon than it must pay soon. Below one is treated as risky.
The book points out an odd result. Many businesses with durable advantages have current ratios below one. The reason is their strength, not their weakness: their earnings are so reliable that they do not need a large cushion, they can borrow short-term cheaply whenever they need to, and they return surplus cash through dividends and buybacks. Some also collect cash from customers before paying suppliers, which keeps current assets low relative to payables.
For these companies, the current ratio says very little. The lesson is broader than one ratio: rules built for average businesses can misread exceptional ones. Context matters.
When the current ratio does matter
For a business without reliable earnings or easy access to credit, which includes most small businesses, the current ratio remains a useful warning. A small business with a current ratio well below one, irregular profits and no undrawn finance facility may struggle to pay its bills on time if anything goes wrong. A related measure, the quick ratio, excludes inventory, since stock cannot always be turned into cash quickly.
A worked example
A small business distributes specialty kitchen equipment to restaurants. This is an illustration.
Sales are growing at 30% a year and the business is profitable, yet the owner finds the bank account constantly tight. A review of the balance sheet shows why.
To support growth, the business has expanded its range, and inventory has grown faster than sales: days inventory has risen from 50 to 80. To win new restaurant accounts, it has offered 60-day terms, and days sales outstanding has risen from 35 to 62. Suppliers, meanwhile, still require payment in 30 days.
The cash conversion cycle has stretched from 55 days to 112. Growth has turned profit into stock and receivables rather than cash.
The owner acts on three fronts. Slow-moving lines are discontinued and stock levels set by actual sales history. New accounts receive 30-day terms, with a small discount for payment within 14 days, and overdue accounts are followed up weekly. Two key suppliers agree to 45-day terms in exchange for larger, more predictable orders.
Within a year, the cycle falls to around 60 days, releasing several hundred thousand dollars of cash, and the business funds its continued growth without additional borrowing.
What this means for running a business
The same lines are a practical dashboard for any operating business.
Track where your cash comes from. Cash from trading is strength; cash from borrowing is a loan against the future.
Watch stock against sales. Inventory that grows faster than sales ties up money and often hides a demand problem.
Be careful with payment terms. Longer terms can win customers, but they also fund those customers with your money. Prompt payment is a sign that customers genuinely value what you sell.
Collect consistently. Clear terms, prompt invoicing and polite, regular follow-up make a large difference to days sales outstanding.
Know your cash conversion cycle. Calculate it quarterly. Shortening it is often the cheapest source of funding available.
Pay suppliers fairly. Using supplier credit sensibly is good management; stretching it to breaking point damages relationships you depend on.
Keep enough cash for a bad year. Until earnings are proven and consistent, a cushion is worth more than the return it forgoes.
Common mistakes
Celebrating growth without watching working capital. Fast growth can consume more cash than it generates.
Judging cash without asking where it came from. Borrowed cash is not earned cash.
Treating all inventory as an asset of full value. Slow-moving stock is often worth far less than its recorded cost.
Ignoring overdue receivables. The longer a debt is outstanding, the less likely it is to be paid.
Applying the current ratio mechanically. It means different things for different businesses.
Questions to ask
- Is cash growing from operations, or from borrowing and asset sales?
- Are inventory and receivables growing faster than sales?
- How do days sales outstanding compare with competitors?
- What is the cash conversion cycle, and which way is it moving?
- For your own business: how much cash would be released if customers paid on time and stock turned ten days faster?
Bringing it together
The short-term section of the balance sheet shows how a business turns its activity into cash. Strong businesses accumulate cash from operations, keep inventory in step with sales, and are paid promptly by customers who value what they offer. Some are so strong that they look weak on traditional liquidity measures, because they simply do not need a large cushion.
For anyone running a business, working capital is where profit becomes real. Managing it well (stock, collections, supplier terms and the cycle that links them) is often the quickest way to strengthen a business without selling a single extra thing.
Source: Mary Buffett and David Clark, Warren Buffett and the Interpretation of Financial Statements (2008). Figures in this article are illustrations, not data. This article is general information, not financial or investment advice.
