Working capital is a financial concept describing the difference between current assets and current liabilities of a business. If current liabilities are greater than current assets, a business has a deficit of working capital, which means it could not pay off its current liabilities using its current assets. Thus, a healthy business should have a surplus of working capital.
Common examples of current assets and current liabilities are shown in the figure below.
All the elements listed above can be found in a company’s balance sheet.
The formula to calculate working capital is rather straightforward.
Working Capital = Current Assets - Current Liabilities
As was mentioned above, working capital is needed for uninterrupted business operations. This constant need is usually financed by long-term debts or equity, but some businesses have seasonal needs that can be funded by short-term financing sources.
The working capital cycle is a period of time that is necessary to convert current assets and current liabilities into cash. The lower number is always favorable due to lower expenses tied to the cost of capital. The formula is expressed as follows:
As we can see, the cycle time can be reduced by either increasing the number of days of payables outstanding or by decreasing the number of days of inventory outstanding and days of sales outstanding. Each way has its own drawbacks.
It is necessary to reduce the average stock level to reduce the number of days of inventory outstanding that could lead to production problems and hurt sales. To decrease the number of days of sales outstanding, a company should carry out a tougher credit policy, but this could also damage sales. Finally, to increase the number days of sales outstanding, a company should increase the average accounts payable balance that will negatively affect a company’s liquidity.
The balance sheet of XYZ Company is as follows:
Balance sheet, US$ in thousands
Moreover, if a company reported net sales of $45,320,600, cost of goods sold of $27,625,500, and inventory purchases of $21,250,000, the proportion of credit sales in the current year was 70%.
The working capital at the beginning of the current year is $2,250,000, at the end of the current year $2,425,000, and the average value is $2,425,000.
Working Capital as of December 31 20X7 = $8,300,000 - $6,050,000 = $2,250,000
Working Capital as of December 31 20X8 = $9,550,000 - $6,950,000 = $2,600,000
|Average Value of Working Capital =||$2,250,000 + $2,600,000||= $2,425,000|
To compute the working capital cycle, we need to find the number of days of sales of inventory (DSI), the number of days of sales outstanding (DSO), and the number of days of payables outstanding (DPO) using the formulae below.
|DSI =||Average Inventory||× Number of Days in a Period|
|Cost of Goods Sold|
|DSO =||Average Trade Receivables||× Number of Days in a Period|
|Net Credit Sales|
|DPO =||Average Trade Payables||× Number of Days in a Period|
The average inventory is $3,525,000, the average trade receivables is $2,975,000, and the average trade payables is $3,525,000.
|Average Inventory =||$4,150,000 + $2,900,000||= $3,525,000|
|Average Trade Receivables =||$2,650,000 + $3,300,000||= $2,975,000|
|Average Trade Payables =||$3,650,000 + $3,400,000||= $3,525,000|
Net credit sales = $31,724,420 ($45,320,600 × 70%). Let’s put this data into the formulas above.
|DSI =||$3,525,000||× 365 = 46.6 Days|
|DSO =||$2,975,000||× 365 = 34.2 Days|
|DPO =||$3,525,000||× 365 = 62.7 Days|
Thus, the working capital cycle of XYZ Company is about 18 days (46.6 + 34.2 - 62.7).