Definition
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.
Elements 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.
Formula
The formula to calculate working capital is rather straightforward.
Management of working capital
The goal of managing working capital is to allow continuous operations amid reducing operating cycle. It allows increasing free cash flow (FCF) and therefore increasing economic value added (EVA).
- Cash management. The key point is to determine the cash balance necessary for allowing uninterrupted financing of operations and reducing the holding cost of cash.
- Receivables management. The goal is to set up a credit policy attractable to buyers, which allows collecting time to be reduced.
- Inventory management. The focus is to identify order quantity, stock level, and safety stock, which allows uninterrupted operations and minimizes capital invested in inventory, holding cost, and ordering cost.
- Short-term financing management. The idea is to identify appropriate sources to fund seasonal or unexpected needs in working capital.
Sources of working capital financing
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.
- Short-term loan. If a business needs additional temporary working capital, a short-term loan (maturity is less than 12 months) is a useful source of financing.
- Line of credit. If there is uncertainty when additional needs arise, a line of credit can help meet additional requirements.
- Factoring. This source of financing is rather expensive but can be used when other sources are unavailable.
- Trade receivables. If a business has a good reputation, it can ask trade creditors to extend collection terms, i.e., from 30 days to 40 days, but an increase in trade receivables is not a good sign for other creditors.
- Equity financing. Retained earnings are a widely used source of financing, but in some rare instances owners can provide additional funds.
Working capital cycle
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.
Calculation example
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 = $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.
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) / 2 = $3,525,000
Average Trade Receivables = ($2,650,000 + $3,300,000) / 2 = $2,975,000
Average Trade Payables = ($3,650,000 + $3,400,000) / 2 = $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 / $27,625,500 × 365 = 46.6 Days
DSO = $2,975,000 / $31,724,420 × 365 = 34.2 Days
DPO = $3,525,000 / $21,250,000 × 365 = 62.7 Days
Thus, the working capital cycle of XYZ Company is about 18 days (46.6 + 34.2 – 62.7).