Introduction

Most significant new projects for a business require investments in Working Capital, and this harms a company’s cash flow. Proper cash management is essential if we want the company to continue to operate in the future. A business can be profitable, but if it can’t keep cash on hand, it won’t survive. Therefore it is crucial to use all financial metrics at our disposal to manage cash availability regularly.

Working Capital is used to determine the sufficiency of Current Assets compared to Current Liabilities and their liquidity. We need this information to know if an organization needs additional funding for its operations in the long run or has excess cash that we can shift towards long-term investments.

What is Working Capital?

Working Capital (WC), or Net Working Capital, is a measure of a company’s liquidity and operational efficiency and its financial health. It represents a company’s ability to cover its short-term liabilities with its short-term assets.

We calculate Working Capital with the formula:

A substantial positive Working Capital means the company has the potential to invest its excess cash into long-term assets. A negative metric, on the other hand, might lead to troubles with growth or paying obligations, and might even lead to bankruptcy.

It is important to remember that high Working Capital is not always a good thing. It can be due to overstocking with inventory, which may become slow-moving (hard to realize), or even obsolete. To make sure they are not keeping old parts and raw materials, companies would perform a SLOB (Slow-moving and Obsolete) analysis. And negative Working Capital doesn’t always mean a bad thing. It can mean the company has a healthy and highly efficient WC management with fast receivables collection and inventory sale, just in time to cover arising obligations and purchase more inventory without tying up cash. Or the business might also have an unused revolving credit line that it can utilize.

Working Capital is an essential metric in financial analysis, as it shows creditors and potential investors if the company can pay its short-term payables within one year. The challenge we face is in correctly classifying the assets and liabilities on the balance sheet as current and non-current.

Current Assets

The short-term assets of the company are those it can liquidate within twelve months. They are both intangible and tangible and represent what the company currently owns. The current assets include cash and cash equivalents, stocks, and bonds that can be quickly converted to cash, accounts receivable. They exclude illiquid items like hedge funds, property, slow-moving inventory, bad debt, and others.

Long-term assets like properties can sometimes also be classified as current when, for example, a buyer is lined up.

Current Liabilities

The short-term liabilities of the company are those that the company has to settle within the next twelve months. They consist of all debt and expenses that we expect to pay within one year. It’s mostly the regular costs of running the business, like utilities, payroll, materials, interest on debt, and other accrued expenses and obligations. We also classify long-term debt and other liabilities that are maturing during the year as current liabilities.

Working Capital Changes

Working Capital is not depreciated or amortized like fixed assets. Instead, we expense it in the same period, when we recognize the revenue it helped generate.

However, Working Capital can still lose value. Clients can have difficulties covering their obligations, which may lead to doubtful debt allowances or even balances being written-off. Inventory obsolescence can also be a severe issue. The company would have to write its value down to net realizable value (as stipulated by IAS 2), which will result in the loss of Working Capital value.

And if there’s a too significant devaluation, the company may face the need to use long-term assets to cover the deficit, which is a costly way to finance additional Working Capital. Companies might sometimes try to increase cash by forcing suppliers to grant them better credit terms. Such solutions might work for a while, but are inefficient in the long run, as they do not address the underlying issues, leading to loss of Working Capital value.

Performing Working Capital Analysis

Financial analysts perform working capital analysis following some version of the following approach

1. Prepare an aging report with smaller time buckets for all accounts payable. Usually, we would go for a week-by-week review and look at when amounts are due. Then we will review all other obligations and accrued liabilities and layer those on top of the aging report. Combining those, we will arrive at a detailed overview of when we have to settle all obligations.
2. We then perform the same procedure for accounts receivable, summarizing when we expect to receive cash every week. It is essential to adjust for clients who have historically shown delays in settling their balances, which will provide for a more accurate assessment of the incoming cash flows.
3. Analysts would also look into investments and inventory and analyze how fast they can convert these into cash. It is crucial to keep in mind that if the liquidation of an asset is going to take longer than the time obligations are due, we might exclude said assets from our analysis altogether.
4. The last step is to combine the three schedules from the previous actions into a new cash flow projection. Financial analysts would then look at possible times when there are cash deficits, meaning cash needed to settle obligations is more than the cash we expected clients to pay and the liquidation of other assets. In such circumstances, we should look at options to postpone any payments to cover shortages. If that is not possible, we might have to consider options to secure additional funding.

This Working Capital analysis is something we should regularly perform, as the company’s current assets and liabilities are subject to constant change, and we calculate them on a twelve-month basis.

A Working Capital in line or above the industry average for similarly sized companies is one we usually consider acceptable.

Working Capital analysis helps managers foresee financial difficulties that may arise. It also shows potential investors the ability of the company to get through financially challenging periods. Businesses should strive to maintain a high enough Working Capital, that they can manage unpredictable struggles.

When modeling Working Capital, we face the challenge of determining the proper drivers that influence each WC line. These have a tight connection to the performance of the business. The most popular method to forecast Working Capital is the Cash Conversion Cycle, which looks into the time it takes for the company to complete a full operating cycle. We can use this approach to forecast the Working Capital balances that are a part of the Balance sheet, and also play a role in forming the Cash flow from operating activities in the Cash Flow Statement.

Working Capital Turnover Ratio

We can use the WC Turnover Ratio, or Net Sales to WC Ratio, to measure the company’s effectiveness in Working Capital management. To calculate it we use the formula:

The Ratio is useful for analysts to benchmark the business against competitors or analyze its development over time.

Current Ratio

The Net Working Capital has a direct link to the Current Ratio. If you look at both metrics, we rely on the same Balance Sheet data for their calculation.

To calculate the Current Ratio, we can employ the following formula:

A ratio below zero means we have a negative Net Working Capital. Current Ratio above zero and less than one is considered risky. It can indicate the company will struggle to cover its short-term debt.

And a Current Ratio of above two may indicate that the company can benefit from better managing its current assets, or shoulder.

Quick Ratio (Acid Test)

The Quick Ratio, also known as Acid Test, is a more strict version of the Current Ratio. It excludes inventory from the formula, as it is usually harder to liquidate than receivables, stocks, and bonds. This changes the equation to:

Improving Working Capital

There are a lot of strategies and methods that can be employed to try and free up more cash. These depend on the industry and will vary for different businesses. Some ways to improve Working Capital can be:

• Sell long-term assets that are not utilized by the company;
• Sell long-term assets and lease them back so that the business can continue its operations;
• Increase inventory turnover and limit slow-moving inventory;
• Offer incentives to clients if they pay in shorter periods;
• Refinance short-term or expensive debt with long-term debt, to stretch out the payment schedules.

Example

To better illustrate the concepts outlined above, we will look at an example. We have exported our payables due and expected receivables for the period 1st of March to the end of June. We then create a summary outlining the Net cash flow and the resulting Net cash balance. We notice that in weeks 13 to 16, we have issues with our cash flow.

To cover our obligations, we can liquidate some short-term investments. By employing this strategy, we can remedy our cash issues in Week 13.

After reviewing our other investments, we cannot identify any additional positions that we can liquidate in time to cover our upcoming obligations.

We explore other options and manage to negotiate a short-term revolving credit line from our financing institution. We utilize it in week 14 and get a cash inflow of 100 thousand euros.

Doing so solves our cash flow issues and results in a positive cash flow projection for the company. Keep in mind that we still have to review our cash in-flows for clients that have historically been late in settling their dues, and also look into possible extensions of credit terms with suppliers. The model presented above is a simplified example, aiming to illustrate the concepts behind Working Capital analysis.

You can download the Excel file for this example below.

Conclusion

Working Capital is a powerful metric, as it can quickly provide a current snapshot of the company’s position. It is a measure of operational efficiency and financial health and can help us foresee and timely react to issues that can potentially lead to solvency problems for the business.

It is essential to know that Working Capital alone is not enough to conclude. We need to have a context to figure out what the current amount means.

Companies need to analyze and manage their Working Capital and operating cycle (Cash Conversion Cycle). They need to understand how these work and what they mean for the company, as this is paramount for normal operations.

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