Tuesday, February 7, 2012

Working Capital Primer: How is it that this Capital Works?

In the last Treasury Café post, “Cash Conversion Cycle – A Good Measure?”, we discussed one potential metric to evaluate our organization’s working capital proficiency.
Taking a step back from that post, we can consider the fact that working capital is many things:
·         Well understood
·         Always accounted for
·         Strategically assessed
…not being among them!
What exactly is working capital? What are the differences in how working capital can be evaluated? How can working capital be financed?
We touch on the answers to these questions here.

What Is Working Capital?
According to Investopedia, Working Capital is “the cash a business requires for day-to-day operations, or, more specifically, for financing the conversion of raw materials into finished goods, which the company sells for payment.“
According to Wikipedia, Working Capital is “a financial metric which represents operating liquidity available to a business, organization or other entity”
Cash generation and usage, liquidity, and financing of operations are at the heart of working capital.

Working Capital Example
In a small group meeting we can illustrate the definitions above as follows:
We have 4 people – Charlie, her parents, her customers, and her suppliers.
First Month
Charlie needs to buy raw materials to turn into widgets for her customers, and pay people to run the machines, and pay the landlord rent, and the equipment supplier their lease payment, and the investors their dividends and interest. All this costs her ²10 (for new readers, ² is the symbol for Treasury Café Monetary Units, or TCMU’s), and she needs to deliver this by the end of the month. We call these people, in aggregate, suppliers.
However, since she just started out, Charlie does not have this ²10, so she borrows it from her parents. At month end she pays the suppliers and delivers widgets to her customers. The cash pattern for this is depicted in the figure "First Month".
Recurring Month
The following month end, customers give Charlie ²10 for the widgets they got at the end of last month. Furthermore, Charlie in turn gives ²10 to her suppliers again for the current month’s activity. This pattern will repeat each month, as shown in the figure "Recurring Month".

Notice that Charlie’s parents do not ever get their funds back during this process. This is because the original ²10 is continually being re-cycled to fund the operations.
Let’s say after a period of time Charlie decides to close down. The final month’s cash flow will be depicted in the "Final Month" diagram.
Final Month
Charlie is finally able to pay back her parents!
Notice the critical nature of the working capital investment in this case - Charlie only has the funding to pay it off once the operations related to it are over.
This concept of “over” is important, and we will get back to it shortly.
Note that this example above can be conducted in small settings with real funds to illustrate the point with only the initial ²10. If you would like to do this, the only addition step you would need to do  would be to move the ²10 between supplier and customer due to “all other economic activity” or something during the period. This is sometimes helpful for non-finance types to understand experientially what working capital is.

Working Capital Classification
Working Capital is often classified as “temporary” or “permanent”. This system comes about if we consider the organization’s assets by class over a period of time. The graph on the right depicts a cyclical firm with fixed assets and working capital assets (demarcated by the solid brown line). It then further divides the working capital assets (by way of the dotted red line) into permanent and temporary.
Permanent working capital assets are from the point of the fixed assets to the trough of the cycle. They are defined as such because they always exist no matter where we are in the cycle.
Temporary working capital assets are defined as those between trough and peak. They are defined as such because they disappear at a certain point in the cycle, and their value varies depending on where we are in time.
Often the distinction between the two can get confusing. This is where our concept of “over”, discussed earlier, can be helpful.
A business unit, eager to close the sale on a new deal, might argue that its capital cost should reflect short-term rates because the cash conversion cycle for this will be 40 days. However, we can ask “will the business with this customer be over then?” If we find that “No, we will be doing a new deal with them next month if this goes well, and every month thereafter” rather than “Yes, it is a one-shot deal” then the working capital looks to be more permanent and longer-lived (as Charlie’s parents have learned!).
Over time, a firm’s “permanent” and “temporary” working capital will vary. Looking at a graph of a firm growing over time can be illustrative. In this example, both the level of permanent working capital and temporary working capital grows along with the firm.

Financing Working Capital
Financing working capital assets is not an exact science. Some will tell you that the “permanent working capital” portion should be financed with long-term, “permanent” capital (i.e. long-term debt and equity), for the reason that it is permanent and therefore should be financed with something that matches the tenor.
This point of view can be explained by taking Charlie’s parents’ perspective of the situation. In our example above, they provide capital they do not get back until the firm closes its doors, as near a definition to permanent as any free-market enterprise can entertain! They therefore should expect a return commensurate with other long-term investment alternatives.
Alternatively, some would argue that working capital assets be financed at short-term capital rates. This argument relies in part on a different application of the matching principle – short-term assets should be financed by short-term liabilities.
If we consider a liquidation scenario where each investor gets a specific slice of the firm as collateral, then the working capital investors have less to worry about – customers pay their bills in full when due or face enforceable collection efforts, and any finished inventory can be sold for close to market prices provided it is not obsolete for some reason.
Investors with factory equipment, buildings and land face a lot more variability around the ultimate monetary realization and its’ timing. Thus, since the specific nature of the risk and the timing of its occurrence are different, that should lead us to conclude that the investments are different and require different treatment.
We can illustrate how funding can be short-term by modifying our original Charlie example slightly. If, once we collect from customer, add two additional steps to the process, 1) paying back her parents, and then 2) obtaining ²10 either by re-borrowing from her parents or from a new source, prior to her payment to the suppliers. Under this scenario, the provider of working capital funding gets to choose each month whether to continue it or not. Conversely, Charlie is at risk of not obtaining it each and every month as well.
Of course, any point between these two extremes can be chosen as well. We will look at this a little more in-depth in the next Treasury Café post.

Key Takeaways
Working Capital funding is an essential component of the firm’s financial strategy, and working capital requirements are an important factor to consider as the firm evaluates its opportunities and its needs.
·         Does everyone in your organization have a solid understanding of Working Capital?
·         Do you have a preference as to Working Capital financing? Why?

Add to the discussion with your thoughts, comments, questions and feedback! Please share Treasury Café with others. Thank you!


  1. Dave, as always your financial explanations are on the money. Thanks for increasing my understanding of working capital.

    Now where do I find some? ;-)

    1. Lee,

      What a great question! For some reason working capital is much easier to write about than to find!

      Thank you for taking the time to participate.

  2. This is the best explanation of the matter so far I found on the internet.

    I have a question:
    In a basic way: When it comes to projecting the company's working capital for the comping years, can we say that, the working capital amount (CA-CL) for each of the coming years is basically the amount needed to finance working capital?
    At the same time we look at projected cash flow statement and see for that particular year what amount of (change in working capital) have took place, which is the amount deducted/added from (Net income + dep.). to arrive at operating cash flow, that has already accounted for the working capital?
    I don't know if I make sense or not.

    Many thanks, David.

    1. Muaath,

      Thank you for the questions. If we are projecting the upcoming years, we need to also be sure to project the working capital components. For example, sales will increase 10% each year for the next 3 years. Then along with that we need to think about how AR will also increase during that time. There are different methods we can use - increase them 10% as well, or assume they pay in x days and compute that out over the time period. In addition, we need to decide how inventory is impacted and account for that as well, and then how we will pay for that inventory.

      At the end we will have adjusted AR, Inventory, and AP for our sales increase assumption, and then yes, the net change of this will show how much additional financing will be required to fund the working capital.

      As a caution, I generally do not use Current Assets - Current Liabilities because they can capture non-working capital items (current portion of long term debt, cash, short-term line of credit borrowing, etc.). I like to back out cash and short term borrowing because these are how we finance the working capital, and are not the working capital itself, so including them in the calculation gives me a distorted view of my true amount of working capital.

      These changes should be reflected on the cash flow statement as well. Operating cash flow generally captures the working capital financing need, as the funding for it will appear in either the financing section (short term borrowing) or change in cash on hand. However, since it also includes the results of our operations, if we want to isolate the working capital component itself we will need to go through the operating cash flow section line by line and pick out the working capital items (change in AR, inventory etc.) to understand its impact.

      Does this help?

  3. Thank you David for the explanation, it really helps.
    I have one more question, in regard to G&A and S&D expenses. How these are reflected in terms of cash in the cash flow statement?
    It is already considered in Income Statement, though some are not cash out yet.

    1. Muaath,

      Thank you for the question. One way to think about the cash flow statement is that it provides a 'bridge' between the income statement and the balance sheet.

      If we drew a T-account for a G&A accounting entry, say a departments salary, the entry would hit an expense category (such salary) and a balance sheet category (such as salary's payable). To the extent that the salary's have not been paid, this category will show an increase, and this change in the balance sheet number will be picked up in the cash flow statement under some heading (like accrued liabilities). Once paid, the entry would be to credit cash and debit the balance sheet account, bringing it back down to where it was before.

      Does this help answer your question?