19.2: What Is Working Capital?

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Learning Objectives

By the end of this section, you will be able to:

Define working capital.
Calculate a firm’s operating cycle and cash cycle.
Compute inventory days, accounts receivable days, and accounts payable days.

The concept of business capital is often associated with the cash and assets (such as land and equipment) that the owners contributed to the business. Early political economists like Adam Smith and Karl Marx identified this concept of capital, along with labor and entrepreneurship, to be the factors of production.

That general idea of capital is important and critical to a company’s productive capacity. This chapter is about a specific type of capital— working capital—that is just as important as long-term capital. Working capital describes the resources that are needed to meet the daily, weekly, and monthly operating cash flow needs. Employees are paid out of working capital as well as cash from operations, the fulfillment of merchandise orders is possible because of working capital, and the liquidity of a company hinges upon how well management plans and controls working capital.

Understanding working capital begins with the concept of current assets—those resources of a business that are cash, near cash, or expected to be turned into cash within a year through the normal operations of the business. Current assets are necessary for the everyday operation of the firm, and they are synonymous with term gross working capital.

Cash is needed to pay the bills and meet the payroll. Excess cash is invested in cash alternatives such as marketable securities, creating liquidity that can be tapped when operating cash flow needs exceed the amount of cash on hand (checking account balances). Investment in inventory is necessary to meet the demand for products (sales), and if the firm extends credit to its customers so that a sale can be made, the balance sheet will also show accounts receivable—a very common current asset that derives its value from the probability that customers will pay their bills.

Working capital is often spoken about in two versions: gross working capital and net working capital. As was previously stated, gross working capital is equivalent to current assets, particularly those that are cash, cash-like, or will be converted to cash within a short period of time (i.e., in less than one year).

Net working capital (NWC) is a more refined concept of working capital. It is best understood by examining its formula:

\[\text { Current Assets }- \text { Current Liabilities} = \text{Net Working Capital} \tag{19.1}\]

Goal of Working Capital Management

The goal of working capital management is to maintain adequate working capital to

meet the operational needs of the company;
satisfy obligations (current liabilities) as they come due; and
maintain an optimal level of current assets such as cash (provides no return), accounts receivable, and inventory.

Working capital management encompasses all decisions involving a company’s current assets and current liabilities. One very important aspect of working capital management is to provide enough cash to satisfy both maturing short-term obligations and operational expenditures—keeping the company sufficiently liquid.

In summary, working capital management helps a company run smoothly and mitigates the risk of illiquidity. Well-run companies make effective use of current liabilities to finance an optimal level of current assets and maintain sufficient cash balances to meet short-term operating goals and to satisfy short-term obligations. Working capital management is accomplished through

cash management;
credit and receivables management;
inventory management; and
accounts payable management.

Components of Working Capital Management

In contrast to net working capital, gross working capital is synonymous with current assets, particularly those current assets that are either cash or cash equivalents or that will be converted to cash within a short period of time (i.e., in less than one year).

Below is a list of the components of gross working capital.

Cash and cash equivalents
Marketable securities
Accounts receivable
Inventory

Here is an example. On December 31, a company has the following balances and gross working capital:

A balance sheet of a company shows cash and equivalents ($100,000), marketable securities ($250,000), accounts receivable ($330,000), inventory ($425,000), and the total gross working capital of $1,105,000.

Think of the $1,105,000 of gross working capital as a source of funds for the most pressing obligations (i.e., current liabilities) of the company. Gross working capital is available to pay the bills. However, some of the current assets would need to be converted to cash first. Accounts receivable need to be collected, and inventory would need to be sold before it too can become cash. What if the company had $600,000 of current liabilities? That amount of current obligations could not be paid out of cash until the marketable securities were sold and a significant portion of accounts receivable were collected.

The second, more refined and useful concept of working capital is net working capital:

\[\text { NWC }=\text { Current Assets }- \text { Current Liabilities } \tag{19.2}\]

For example, if a company has $1,000,000 of current assets and $750,000 of current liabilities, its net working capital would be $250,000 ($1,000,000 less $750,000).

NWC provides a better picture because it takes into account the liability “coverage” provided by the current assets. As the above example shows, the current assets would “cover” the current liabilities with an excess of $250,000. Think of it this way: if the current assets could be converted to cash, they could be used to meet the current obligations with another $250,000 of cash leftover.

Current liabilities include

accounts payable;
dividends payable;
notes payable (due within a year);
current portion of deferred revenue;
current maturities of long-term debt;
interest payable;
income taxes payable; and
accrued expenses such as compensation owed to employees.

Net working capital possibilities can be thought of as a spectrum from negative working capital to positive, as explained in Table 19.1.

Table 19.1: Spectrum of Net Working Capital
Negative Net Working Capital	Zero Net Working Capital	Positive Net Working Capital
Current liabilities are greater than current assets.	Current assets equal current liabilities.	Current assets are greater than current liabilities.
Could indicate a liquidity problem. There is difficulty satisfying current obligations.	Indicates that current assets could cover current obligations. However, there is no positive margin (safety cushion) or “liquid reserve” to satisfy unexpected cash needs.	Indicates that the company can meet its current obligations. However, excessively high net working capital could mean too little cash and therefore an opportunity cost (forgoing rates of return on alternative investment).

Measures of Financial Health provides information on a variety of financial ratios to help users of financial statements understand the strengths and weakness of companies’ financial statements. Three of the financial ratios covered in that chapter are brought back into this chapter’s discussion to demonstrate how financial managers examine working capital and liquidity. Liquidity is the ease with which an asset can be converted into cash. Those ratios are the current ratio, the quick ratio, and the cash ratio. A higher ratio indicates a greater level of liquidity.

The formulas for the three liquidity ratios are

\[\begin{align}
\text { Current Ratio } & =\frac{\text { Current Assets }}{\text { Current Liabilities }} \nonumber \\[4pt]
\text { Quick Ratio (Acid Test) } & =\frac{\text { Current Assets-Inventory }}{\text { Current Liabilities }} \nonumber \\[4pt]
\text { Cash Ratio } & =\frac{\text { (Cash }+ \text { Marketable Securities) }}{\text { Current Liabilities }} \nonumber
\end{align} \tag{19.3}\]

Notice how the current ratio includes the two elements of net working capital—current assets and current liabilities. It makes for a quick comparison of relative size or proportion.

Think It Through: Current Ratio

A company has $2,000,000 of current assets, while its current liabilities are $1,000,000. What is the current ratio, and what does it mean?

Solution

The current ratio would be $2 = $ 2,000,000 / $ 1,000,000,$ which is a 2:1 proportion of current asset value to the amount of the current liabilities. This means that if all the current assets could be converted to cash, then the current liabilities could be satisfied two times.

There are two drawbacks to the current ratio: (1) it is a working capital analytic as of a point in time but is not indicative of future liquidity or future cash flows and (2) as an indicator of liquidity, it can be deceptive if a significant proportion of the current assets are inventory, supplies, or prepaid expenses. Inventory is not very liquid as it can take an extended time period to convert to cash, and assets such as supplies and prepaid expenses never become cash and therefore are not a source of funds to pay bills.

The quick ratio is considered a more conservative indication of liquidity since it does not include a firm’s inventory:

\[\dfrac{\text {CurrentAssets - Inventory}}{\text{Current Liabilities}}. \nonumber\]

Think It Through: Quick Ratio

A company’s current assets total $2,000,000, but $500,000 of that is inventory and the current liabilities total $1,000,000. What is the quick ratio, and what does it mean?

Solution

The quick ratio would be $1.5 = $ 1,500,500 / $ 1,000,000$ and would indicate a smaller cushion of net working capital.

Think It Through: Cash Ratio

The cash ratio is even more conservative in that it presents a picture of liquidity by excluding all current assets except cash and marketable securities.

A company’s total current assets are $2,000,000, but only $1,100,000 of the current assets consist of cash and marketable securities. Assuming $1,000,000 of current liabilities, what would be the cash ratio and what does it mean?

Solution

The cash ratio would be $1.1 = $ 1,100,000 / $ 1,000,000,$ and the amount of cash is enough to pay the current bills by $100,000.

Working capital ratios, like any financial ratio, are most valuable when examined in light of trends and in comparison to industry/peer averages. For example, a deteriorating current ratio over several quarters (a decline in the company’s current ratio) could indicate a reduced ability to pay bills.

Working capital ratios are also compared to industry averages, which are available in databases produced by such financial publishers as Dun & Bradstreet, Dow Jones Company, and the Risk Management Association (RMA). These information services are available via subscriptions and through many libraries. For example, if a company’s current ratio is 0.9 while the industry average is 2.0, then the company is less liquid than the average company in its industry and strategies, and techniques need to be considered to change things and to better compete with peer groups. Industry averages can be aspirational, motivating management to set liquidity goals and best practices for working capital management.

It is common to think about working capital with a simple assumption: current assets are being “financed” by current liabilities. However, such an assumption may be an oversimplification. Some level of current assets is often necessary to meet longer-term obligations, and in that way, you could think of some amount of current assets as a permanent based of working capital that may need to be financed with longer-term sources of capital.

Think of a company with seasonal business. During busy times, more working capital will be needed than during certain other portions of the year, such as less busy times. But there will always be some level—a permanent base—of working capital needed. Think of it this way: the total working capital of many companies will ebb and flow depending on many variables such as the operating cycle, production needs, and the growth of revenue. Therefore, working capital can be thought of as having a permanent base that is always needed and a total working capital amount that increases when activity levels (i.e., production and sales volume) are higher (see Figure 19.2).

The Cash Cycle

The cash cycle, also called the cash conversion cycle, is the time period between when a business begins production and acquires resources from its suppliers (for example, acquisition of materials and other forms of inventory) and when it receives cash from its customers. This is offset by the time it takes to pay suppliers (called the payables deferral period).

A graph shows the correlation between the permanent working capital, temporary working capital, and time. The permanent base of working capital rises steadily over time. The temporary total working capital repeatedly increases and decreases over time. The combination of the temporary working capital and permanent working capital is the total working capital. — Figure 19.2: Working Capital Needs Can Vary: Temporary and Permanent Working Capital

The cash cycle is measured in days, and it is best understood by examining its formula:

\[\text{Cash Cycle}=\text{Inventory Conversion Period} + \text{Receivables Collection Period} - \text{Payables Deferral Period} \tag{19.4}\]

The inventory conversion period is also called the days of inventory. It is the time (days) it takes to convert inventory to sales and is calculated by following these steps:

First, calculate the Inventory Turnover Ratio using this formula:
\[\text { Inventory Turnover Ratio }=\frac{\text { Cost of Goods Sold }}{\text { Average Inventory }} \tag{19.5}\]
The Average Inventory is arrived at as follows:
\[\text { Average Inventory }=\frac{(\text { Beginning Inventory } + \text { Ending Inventory })}{2} \tag{19.6}\]
Then, use the Inventory Turnover Ratio to calculate the Inventory Conversion Period:
\[\text { Inventory Conversion Period }=\frac{365}{\text { Inventory Turnover }} \tag{19.8}\]

The receivables collection period, also called the days sales outstanding (DSO) or the average collection period, is the number of days it typically takes to collect cash from a credit sale. It is calculated by following these steps:

First, calculate the Accounts Receivable Turnover using this formula:
\[\text { Accounts Receivable Turnover }=\frac{\text { Credit Sales }}{\text { Average Accounts Receivable }} \tag{19.8}\]
The Average Accounts Receivable is arrived at as follows:
\[\text { Average Accounts Receivable }=\frac{(\text { Beginning Accounts Receivable }+ \text { Ending Accounts Receivable })}{2}\tag{19.9}\]
Then, use the Accounts Receivable Turnover to calculate the Receivables Collection Period:
\[\text { Receivables Collection Period }=\frac{365}{\text { Accounts Receivable Turnover }} \tag{19.10}\]

The payables deferral period, also known as days in payables, is the average number of days its takes for a company to pay its suppliers. It is calculated by following these steps:

First, calculate the Accounts Payable Turnover using this formula:
\[\text { Accounts Payable Turnover }=\frac{\text { Cost of Goods Sold }}{\text { Average Accounts Payable }} \tag{19.11}\]
The Average Accounts Payable is arrived at as follows:
\[\text { Average Accounts Payable }=\frac{(\text { Beginning Accounts Payable }+ \text { Ending Accounts Payable })}{2} \tag{19.12}\]
Then, use the Accounts Payable Turnover to calculate the Payables Deferral Period:
\[\text { Payables Deferral Period }=\frac{365}{\text { Accounts Payable Turnover }} \tag{19.13}\]

Think It Through: Periods of the Cash Cycle

Scenario 1: King Sized Products (KSP) Inc. has annual credit sales of $40,000,000. The average inventory is $3,000,000, and the company has average accounts receivable of $6,000,000 and average accounts payable of $2,800,000. The cost of goods sold for KSP Inc. is $30,000,000. The cash cycle for the company is 57.2 days. Calculate the inventory conversion, receivables collection, and payable deferral periods.

Solution

Inventory conversion period:

\[\text { Inventory Turnover Ratio }=\frac{\$ 30,000,000}{\$ 3,000,000}=10 \text { times }\]

\[\text { Inventory Conversion Period }=\frac{365}{10}=36.5 \text { days }\]

Receivables collection period:

\[\text { Accounts Receivable Turnover }=\frac{\$ 40,000,000}{\$ 6,000,000}=6.67 \text { times }\]

\[\text { Receivables Collection Period }=\frac {365}{6.67}=54.7 \text { days }\]

Payables deferral period:

\[\text { Accounts Payable Turnover }=\frac{\$ 30,000,000}{\$ 2,800,000}=10.71 \text { times }\]

\[\text { Payables Deferral Period }=\frac{365}{10.71}=34 \text { days }\]

The solution (the entire cash conversion cycle) is also illustrated in a chart, Figure 19.3.

A bar graph shows the cash conversion cycle. It consists of four cycles- inventory conversion, receivable conversion, payable deferral, and cash conversion. The inventory conversion cycle begins when the inventory is acquired and ends when the inventory is sold; this cycle is 36.5 days long. The receivable conversion cycle begins when the inventory is sold and ends when the receivable is collected; this cycle is 54.7 days long. The payable deferral cycle begins before the inventory is acquired and ends when the trade credit is paid; this cycle is 34 days long. The cash conversion cycle begins when the trade credit is paid and ends when the receivable is collected; this cycle is 57.2 days long. — Figure 19.3: Cash Conversion Cycle

Shortening the inventory conversion period and the receivables collection period or lengthening the payables deferral period shortens the cash conversion cycle. Financial managers monitor and analyze each component of the cash conversion cycle. Ideally, a company’s management should minimize the number of days it takes to convert inventory to cash while maximizing the amount of time it takes to pay suppliers.

Quickly converting inventory to sales speeds up cash inflows and shortens the cash cycle, but it also could help reduce inventory losses as a result of obsolescence. Inventory becomes obsolete because of a variety of factors including time—inventory that has not been sold for a long period of time and is not expected to be sold in the future has to be written down or written off according to accounting rules. Write-offs of inventory can result in significant losses for a company. In the food business, inventory conversion periods take on great importance because of spoilage of perishable goods; in retailing, seasonal items lose value the longer they stay on the shelves.

Various inventory management techniques are used to shorten production time in manufacturing, and in retailing, strategies are used to reduce the amount of time a product sits on the shelf or is stored in the warehouse. Production techniques such as just-in-time inventory systems and marketing and pricing strategies can have an impact on the number of days in the inventory conversion cycle.

For the receivables collection period, a relatively long receivables collection period means that the company is having trouble collecting cash from its customers and so whatever can be done to speed up collections while still offering competitive credit terms should be pursued by financial managers. For example, companies that converted paper invoicing to e-invoicing most likely reduce the average collection period by some number of days, as it makes sense that if a bill is transmitted electronically, lag time is cut (no delays because of “snail mail”) and collections (payments back to the company from customers) may happen sooner. Other credit management techniques, some of which are explained in subsequent sections, can help minimize and control the receivables collection period.

The payables deferral period is the one element that probably cannot be optimized without violating credit terms. Certainly, cash balances can be conserved by delaying payments to vendors for as long as possible; however, payments on trade credit need to be made on time or the company’s relationship with the supplier can suffer. In a worst-case scenario, the company’s credit rating could also deteriorate.

A credit rating, also called a credit score, is a measure produced by an independent agency indicating the likelihood that a company will meet its financial obligations as they come due; it is an indication of the company’s ability to pay its creditors. Three business credit rating services are Equifax Small Business, Experian Business, and Dun & Bradstreet.

Think It Through: The Cash Conversion Cycle

Considering the previous Think It Through (Scenario 1), what if you could reduce inventory levels, hold lower accounts receivable balances, and rely more heavily on accounts payable while maintaining the same sales level?

Here’s Scenario 2. Because of better inventory management, credit and collections management, and negotiation of longer payment periods with vendors, King Sized Products (KSP) Inc. needs less investment in inventory and accounts receivable and is able to utilize a greater amount of trade credit financing.

Annual credit sales are $40,000,000, average inventory is $2,800,000, average accounts receivable are $5,500,000, average accounts payable are $3,300,000, and cost of goods sold is $30,000,000. What is the cash conversion cycle?

Solution

Inventory conversion period:

$Inventory Turnover Ratio = \frac{$ 30,000,000}{$ 2,800,000} = 10.71$ timesInventory Turnover Ratio=$30,000,000$2,800,000=10.71 times
$Inventory Conversion Period = \frac{365}{10.71} = 34.07$ daysInventory Conversion Period = 36510.71= 34.07 days
$Inventory Conversion Period = \frac{365}{10.71} = 34.07$ daysInventory Conversion Period=36510.71=34.07 days

Receivables collection period:

$Accounts Receivable Turnover = \frac{$ 40,000,000}{$ 5,500,000} = 7.27$ timesAccounts Receivable Turnover=$40,000,000$5,500,000=7.27 times
$Receivables Collection Period = \frac{365}{7.27} = 50.21$ daysReceivables Collection Period=3657.27= 50.21 days

Payables deferral period:

$Accounts Payable Turnover = \frac{$ 30,000,000}{$ 3, 300,000} = 9.09$ timesAccounts Payable Turnover =$30,000,000$3,300,000= 9.09 times
$Payables Deferral Period = \frac{365}{9.09} = 40.15$ daysPayables Deferral Period=3659.09=40.15 days

Cash Conversion Cycle = 34.07 days + 50.21 days - 40.15 days = 44.13

days

Cash

Conversion Cycle = 34.07 days + 50.21 days – 40.15 days = 44.13 days

19.15

Notice that the investment in inventory and accounts receivable is less and the average accounts payable is more with no change in credit sales and cost of goods sold—you would certainly anticipate a reduction in the cash conversion cycle. The improvement would be about 13 days (from 57.2 in Scenario 1 to 44.1 days in Scenario 2). Figure 19.4 shows a bar chart comparison of the two scenarios.

Table 19.2
	Scenario 1	Scenario 2
Inventory Conversion Period	36.50	34.07
Receivables Collection Period	54.75	50.21
Payables Deferral Period	34.07	40.15
Cash Conversion Cycle	57.18	44.10

A bar graph is used to compare the cash conversion cycles for two scenarios. Scenario 2 has slightly shorter inventory conversion and receivables collection periods, while Scenario 1 has a slightly shorter payables deferral period. The cash conversion cycle is longer in Scenario 1 than it is in Scenario 2. — Figure 19.4: Scenario 1 and 2 Comparison: Shortening the Cash Conversion Cycle

Link to Learning

A Harvard Business School blog post, How Amazon Survived the Dot-Com Bubble, discusses how Amazon managed its cash conversion cycle to the point where it was receiving payment for the things it sold before Amazon had to pay for them. In that way, Amazon had a negative cash conversion cycle (which is really a huge positive for a company trying to manage positive cash flow!).

Working Capital Needs by Industry

When comparing working capital needs by industry, you can see some variation. For example, some companies in the grocery business can have very low cash conversion cycles, while construction companies can have very high cash conversion cycles. And some companies, like those in the restaurant business, can have very low numbers and even have negative cash conversion cycles.

Working capital can also differ from one industry to another. An often cited general rule is that a current ratio of 2 is considered optimal. However, general rules of thumb must be treated with caution. A better benchmarking approach is to compare a firm’s ratios—current ratio and quick ratios—to the average of the industry in which the subject company operates.

Take, for example, a home construction company. Such as firm has a long operating cycle because of the production process (building homes), and the “storage of finished goods” can result in very high current ratios—such as 11 or 12 times current liabilities—whereas a retailer like Walmart or Target would have much lower current ratios.

In recent years, Walmart Stores Inc. (NYSE: WMT) has had a current ratio of around 0.9 and has been able to manage its working capital needs by efficient management of its supply chain, quick turnover of inventory, and a very small investment in accounts receivables.¹ Big retailers like Walmart are effective at negotiating favorable payment terms with their vendors. The ability to generate consistent positive cash flow from operations allows a retailer like Walmart to operate with relatively low amounts of working capital.

The credit policies of a company also affect working capital. A company with a liberal credit policy will require a greater amount of working capital, as collection periods of accounts receivable are longer and therefore tie up more dollars in receivables.

Almost all businesses will have times when additional working capital is needed to pay bills, meet the payroll (salaries and wages), and plan for accrued expenses. The wait for the cash to flow into the company’s treasury from the collection of receivables and cash sales can be longer during tough times.

During the COVID-19 pandemic, the US government made paycheck protection program (PPP) loans available to help alleviate working capital problems for small and large business when the economy slowed because of shutdowns and social distancing. And although 60 percent of the PPP loan proceeds were to go to cover payroll-related costs, 40 percent could be used to bolster working capital to meet rent, utilities costs, and some interest expense while companies were “treading water”—waiting for positive cash flow to pick up under a recovery.²

It isn’t just during downturns that working capital is strained. Growing companies, even if they are extremely profitable, need additional working capital as they ramp up operations by acquiring raw materials, component parts, supplies, or other forms of inventory; hiring temporary or additional employees; and taking on new projects. Whenever additional resources are needed, working capital is also needed.

Some of the current assets and expenditures needed in a growing company may need to be financed from sources that are not spontaneous financing—trade credit (accounts payable). Such forms of external financing such as lines of credit, short-term bank loans, inventory-based loans (also called floor planning), and the factoring of accounts receivables might have to be relied upon.

Footnotes

1Walmart Inc. “2020 Annual Report.” 2020. corporate.walmart.com/media-...1-b3fea8490000
2US Small Business Administration. “PPP Loan Forgiveness.” n.d. https://www.sba.gov/funding-programs...an-forgiveness