What Working Capital Is and Why You Should Manage It
Updated: Nov 30, 2020
Working Capital is the excess of current assets (including cash, accounts receivable, and inventory) over current liabilities (including accounts payable and accrued expenses).
Net Working Capital = Current Assets - Current Liabilities
It is a measure of both liquidity and operational efficiency. Ideally, you want to maintain your net working capital (NWC) so you have enough to invest and grow your business. However, too much net working capital can indicate you are not reinvesting cash, not collecting accounts receivable (A/R) efficiently, or over investing in inventory. An important point to note: Inventory is generally thought of as pertaining to businesses that sell products, not services. However, I have always told service providers to think of work completed but not billed as their inventory. A billable hour worked but not invoiced is essentially the same as a widget purchased but not sold. It is an asset that needs to be converted to cash.
Dollars tied up in accounts receivable and inventory are dollars not currently earning a return for your company. Keeping inventory at the optimal level will free up those dollars for investment elsewhere. Likewise, dollars you are entitled to but have not received represent an interest free loan to the party you have extended the payment terms to. The flip side of managing accounts receivable is managing your accounts payable (A/P). These are other firms' extensions of credit to you for the length the payment terms. These represent expenses you have incurred but have not yet outlaid the cash for. Ideally, you will pay these at the end of the payment term period because you want to delay the outlay of cash as long as possible. One possible exception to this is if the vendor offers a discount on early payment (ex. 2/10, net 30). Ordinarily, you should take the discount, especially if you have enough cash on hand and adequate buffer in your cash flow forecast. If you will have to borrow to take advantage of the discount, you will have to calculate the costs of not taking the discount (see equation 1 below) and compare that to the cost of the sources of financing you would utilize.
Effectively managing your collections, inventory, and payments to outside vendors are essential for good working capital management. Specific working capital needs will vary from industry to industry. Different industries have significantly different payments terms (to both suppliers and customers), inventory values, inventory turn rates, etc. There are various metrics you can use to evaluate your firm compared to other players in your industry. Some of these include:
Current Ratio - a measure of liquidity. Current Ratio = Current Assets/Current Liabilities
Cash conversion cycle (CCC)- the number of days it takes to convert a dollar spent on inventory into a dollar inflow from sales, Calculating this number requires you to know your Days Sales Outstanding (a measure of A/R collection efficiency), Days Inventory Outstanding (a measure of inventory management efficiency), and Days Payable Outstanding (a measure of A/P management).
Working Capital Turnover - measures the effectiveness in using working capital to generate sales. Working Capital Turnover = Net Sales / Net Working Capital
Return on capital employed (ROCE) - while not strictly a working capital ratio, it provides a measure of efficiency of generating income from total capital. ROCE = Earnings Before Interest & Taxes / (Total Assets - Current Liabilities)
Finally, a lesser known fact about working capital management is that it often has substantial ramifications on the sale of a business. Commonly buyers of businesses include a NWC target in their agreement, normally based on the 12-month average of the NWC prior to sale (the target amount). This is because the sale price is often based on a multiple of Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA). Thus, all items included in the EBITDA number need to be accounted for. A/R appears in EBITDA as revenue, and A/P shows up as expenses. The working capital needed to generate the selling EBITDA has to be maintained for the price to be fair. Normally the terms of the sale require an adjustment to the purchase price if the working capital varies from the 12-month average. If the NWC at the close of the sale is above the target amount, the seller's closing proceeds are increased by the difference. Conversely, if the NWC is below the target amount at sale, the seller's proceeds are reduced by the difference. Owners considering an outside sale have an additional incentive to manage their working capital, and they should begin managing it at least 18 months prior to going to market to find a buyer. Managing working capital effectively ensures owners (sellers) will have a true representation of the NWC required to run the firm when the buyer calculates the 12-month average, and they will have a strong negotiating position to argue it should be lower if an anomaly has driven it higher in the past few months.
Overall, the goal of net working capital management is to maximize the efficiency of your operations. Effective management of working capital will improve profitability and growth, while ensuring your ability to cover your obligations.
If you would like to learn more, or think your company could benefit from working with Augelli Consulting, LLC please contact us for a free initial consultation at firstname.lastname@example.org.