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What is Working Capital?

Dan Alway Evaluation, Sell A Business

Working capital is the lifeblood of any healthy business. It affects many aspects, from paying vendors and employees to keeping operations on. It also influences the planning of sustainable long-term growth. Without working capital (WC), even the most profitable business will fail.

Also known as net working capital (NWC), working capital is a measure of a company’s ability to pay its current liabilities with the current assets. It shows the company’s short-term financial health, running efficiency, and ability to clear its debts within a year. When WC is too little, it impairs the business’s ability to meet its financial duties. But when it’s too much, it means some assets aren’t being invested as efficiently as they could towards the long-term growth of the business.

Working capital management

Working capital management is a business strategy meant to help a company to run efficiently. It ensures a company has enough cash to pay for its expenses and debts and that it’s investing assets in the most productive way. Management involves tracking three ratios.

  • The working capital ratio
  • Inventory ratio
  • Collection ratio

Maintaining optimal levels of these three ratios ensures efficient working capital management.

Working capital management maximizes asset ROI and minimizes the cost of money spent on WC. It boosts profitability and earnings through the efficient use of resources.

 

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Components of working capital

Current assets

Current assets are intangible and tangible assets. They include things that a company currently owns and can quickly turn into cash within one business cycle or one year, whichever is less. Examples of these assets are:

  • Saving and checking accounts
  • Highly liquid marketable securities like bonds, stocks, exchange-traded funds, and mutual funds.
  • Cash and cash equivalents,
  • Money market accounts
  • Interest payable
  • Account receivable inventory
  • Discontinued operations assets

Long-term illiquid investments like collectibles, real estate, or hedge funds are not current assets. Reason being, is that they don’t turn into cash.

Current liabilities

Current liabilities are all expenses and debts a business expects to pay within one business cycle or year, whichever is less. This includes the day-to-day cost of operating a business like:

  • Utilities
  • Rent
  • Supplies and materials
  • Principal payment in debt or interest
  • Accrued expenses like interests and income taxes
  • Accounts payable
  • Capital leases
  • Dividends payable due in a year
  • Long-term debt that’s almost due

 

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Positive and negative working capital

Working capital can be positive or negative. Positive WC is a good sign of short-term financial health. It shows the business has enough liquidity on hand to offset short-term debts and finance its growth. Without the extra working capital, a company may have to lend more money from outside sources.

A negative working capital means assets are not being used appropriately, and the business may have a liquidity crisis. Even with deep investments in fixed assets, a company will still encounter many financial hurdles when there’s no money to offset liabilities that are due. It may need to borrow more and make late payments to suppliers and creditors. This is not good for the credit rating of the business.

But negative WC is not always a bad thing – especially for businesses that get paid every few days and have a high inventory turnover rate. In this case, a little working capital on hand is a great thing because they generate cash very quickly.

What is the working capital cycle?

This is the time it takes to convert total net working capital into cash. It reflects the efficiency and ability of the company to manage its short-term liquidity position. A shorter cycle means the business gets to free up cash that’s locked in working capital. A longer one means that capital is stuck in the running cycle without yielding any returns. Shortening the cycles enhances short-term liquidity situation and provides a boost in business efficiency.

Working capital cycle revolves around managing four key elements. These are inventory, cash, receivables, and payables. A company must have full control of these critical elements to have a controlled and efficient cycle. Smart businesses manage this cycle by:

  • Increasing sales
  • Increasing the credit period from suppliers
  • Reducing the credit period given to customers.

Here’s how the working capital cycle works for most companies:

  • The company takes materials (on credit) to manufacture a product – and have a set time to pay (let’s assume 90 days)
  • On average, the company sells inventory in 80 days (days payable outstanding)
  • A client gets the products but pays 25 days later

Let’s break this down further. The company buys materials on credit under accounts payable, but will have to repay the amount in 90 days. It sells the finished products 80 days after buying raw materials. However, the company doesn’t get the cash immediately as the goods are sold on credit under accounts receivable. 25 days after selling, the company gets cash, and the working capital cycle completes.

 

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How to calculate working capital

Working capital represents the difference between a company’s current assets and current liabilities. It is calculated using this formula:

Working capital = current assets – current liabilities

Working capital cycle = inventory Days + Receivable Days – Payable Days

Using the above example

WCC = 80 + 25 – 90 = 15

So the company is only out of pocket cash for 15 days before getting all of the payment.

How is the working capital used?

Cash is the lifeline of a business. The company’s ability to fund projects, operations, payments, and capital requirements depend on cash. Working capital is the cash that a business needs to finance operations. More specifically, it’s what finances the conversion of raw materials to finished products, which the business sells for payment.

When it comes to working capital, more is better. It means that the company won’t have a hard time coping with expenses. It also means that there’s a surplus to be invested in other ways to increase the ROI. But since businesses vary, we cannot safely say a specific amount of working capital will guarantee smooth operations. Some sectors, like retail, have varying working capital needs throughout the year. They need additional working capital to finance the extra staff and inventory needed for the holidays. In which case, they will have higher expenses and low revenues in the off-season leading up to their high-demand seasons.

Working capital acts as a buffer when the revenues are low. It takes care of paying staff and other operational needs when sales are low. In case the working capital is not enough, businesses can always opt for a line of credit from banks to weather the storm.