Working capital

Working capital as a ratio is meaningful when it is compared, alongside activity ratios, the operating cycle and cash conversion cycle, over time and against a company’s peers. Taken together, managers and investors gain powerful insights into the short-term liquidity and operations of a business.


Working Capital

As a working capital example, here’s the balance sheet of Noodles & Company, a fast-casual restaurant chain. As of October 3, 2017, the company had $21.8 million in current assets and $38.4 million in current liabilities, for a negative working capital balance of -$16.6 million:

Current Ratio and Quick Ratio

A financial ratio that measures working capital is the current ratio, which is defined as current assets divided by current liabilities and is designed to provide a measure of a company’s liquidity:

As we’ll see shortly, this ratio is of limited use without context, but a general view is that a current ratio of > 1 implies a company is more liquid because it has liquid assets that can presumably be converted into cash and will more than cover the upcoming short-term liabilities.

Another closely related ratio is the quick ratio (or acid test) which isolates only the most liquid assets (cash and receivables) to gauge liquidity. The benefit of ignoring inventory and other non-current assets is that liquidating inventory may not be simple or desirable, so the quick ratio ignores those as a source of short term liquidity:

Working Capital Presentation on Cash Flow Statement

Reconciling Working Capital on the Balance Sheet with CFS

As it so happens, most current assets and liabilities are related to operating activities [1] (inventory, accounts receivable, accounts payable, accrued expenses, etc.) and are thus primarily clustered in the operating activities section of the cash flow statement under a section called “changes in operating assets and liabilities.”

Because most of the working capital items are clustered in operating activities, finance professionals generally refer to the “changes in operating assets and liabilities” section of the cash flow statement as the “changes in working capital” section.

However, this can be confusing since not all current assets and liabilities are tied to operations. For example, items such as marketable securities and short-term debt are not tied to operations and are included in investing and financing activities instead (although in the above example, Noodles & Co happened to not have any marketable securities or short-term debt).

Operating Items vs. Working Capital on the Cash Flow Statement

Adding to the confusion is that the “changes in operating activities and liabilities” (often called the “changes in working capital”) section of the cash flow statement commingles both current and long-term operating assets and liabilities. That’s because the purpose of the section is to identify the cash impact of all assets and liabilities tied to operations, not just current assets and liabilities.

For example, Noodles & Co classifies deferred rent as a long-term liability on the balance sheet and as an operating liability on the cash flow statement [2] . It is thus not included in the calculation of working capital, but it is included in the “changes in operating activities and liabilities” section (which we now know people often also refer to, confusingly, as “changes to working capital”).

Working Capital on Financial Statements

Interpreting Working Capital

Now that we’ve addressed how working capital is presented, what does working capital tell us? Let’s continue with our Noodles & Co example. What does the company’s negative $16.6 million working capital balance tell us?

For starters, it tells us that there are $16.6 million more liabilities coming due over the next year than assets that can be converted within the year. This might seem like a troubling metric. For example, if all of Noodles & Co’s accrued expenses and payables are due next month, while all the receivables are expected 6 months from now, there would be a liquidity problem at Noodles. They’d need to borrow, sell equipment or even liquidate inventory.

But the same negative working capital balance could be telling a completely different tale, namely of healthy and efficient working capital management, where accounts payables, accounts receivable and inventory are carefully managed to ensure that inventory is quickly sold and cash is quickly collected, allowing Noodles & Co to pay invoices as they come due and purchase more inventory without tying up cash and without skipping a beat. Further, Noodles & Co might have an untapped credit facility (revolving credit line) with sufficient borrowing capacity to address an unexpected lag in collection.

Our working capital position benefits from the fact that we generally collect cash from sales to customers the same day, or in the case of credit or debit card transactions, within several days of the related sale, and we typically have up to 30 days to pay our vendors. We believe that expected cash flow from operations, the proceeds received from the private placement transactions and existing borrowing capacity under our credit facility are adequate to fund debt service requirements, operating lease obligations, capital expenditures, the Restaurant Closing Liabilities, the Data Breach Liabilities and working capital obligations for the remainder of fiscal year 2017.

The Operating Cycle

Cash, accounts receivable, inventories and accounts payable are often discussed together because they represent the moving parts involved in a company’s operating cycle (a fancy term that describes the time it takes, from start to finish, of buying or producing inventory, selling it, and collecting cash for it).

In other words, there are 63 days between when cash was invested in the process and when cash was returned to the company. Conceptually, the operating cycle is the number of days that it takes between when a company initially puts up cash to get (or make) stuff and getting the cash back out after you sold the stuff.

Since companies often purchase inventory on credit, a related concept is net operating cycle (or cash conversion cycle), which factors in credit purchases. In our example, if the retailer purchased the inventory on credit with 30-day terms, it had to put up the cash 33 days before it was collected. Here, the cash conversion cycle is 35 days + 28 days – 30 days = 33 days. Pretty straightforward.

Working Capital Management

For many firms, the analysis and management of the operating cycle is the key to healthy operations. For example, imagine the appliance retailer ordered too much inventory – its cash will be tied up and unavailable for spending on other things (such as fixed assets and salaries). Moreover, it will need larger warehouses, will have to pay for unnecessary storage, and will have no space to house other inventory.

Imagine that in addition to buying too much inventory, the retailer is lenient with payment terms to its own customers (perhaps to stand out from the competition). This extends the amount of time cash is tied up and adds a layer of uncertainty and risk around collection.

Now imagine our appliance retailer mitigates these issues by paying for the inventory on credit (often necessary as the retailer only gets cash once it sells the inventory). Cash is no longer tied up, but effective working capital management is even more important since the retailer may be forced to discount more aggressively (lowering margins or even taking a loss) to move inventory in order to meet vendor payments and escape facing penalties.

Taken together, this process represents the operating cycle (also called the cash conversion cycle). Companies with significant working capital considerations must carefully and actively manage working capital to avoid inefficiencies and possible liquidity problems. In our example, a perfect storm could look like this:

In this perfect storm, the retailer doesn’t have the funds to replenish the inventory that’s flying off the shelves because it hasn’t collected enough cash from customers. The suppliers, who haven’t yet been paid, are unwilling to provide additional credit, or demand even less favorable terms. In this case, the retailer may draw on their revolver, tap other debt, or even be forced to liquidate assets. The risk is that when working capital is sufficiently mismanaged, seeking last-minute sources of liquidity may be costly, deleterious to the business, or in the worst-case scenario, undoable.

Components of Working Capital

Current Assets

Current assets are assets that a company can easily turn into cash within one year or one business cycle, whichever is less. They do not include long-term or illiquid investments such as certain hedge funds, real estate, or collectibles.

Examples of current assets include checking and savings accounts; highly liquid marketable securities such as stocks, bonds, mutual funds and exchange-traded funds (ETFs); money market accounts; cash and cash equivalents, accounts receivable, inventory, and other shorter-term prepaid expenses. Other examples include current assets of discontinued operations and interest payable.

Current Liabilities

Current liabilities are all the debts and expenses the company expects to pay within a year or one business cycle, whichever is less. This typically includes the normal costs of running the business such as rent, utilities, materials and supplies; interest or principal payments on debt; accounts payable; accrued liabilities; and accrued income taxes.

6 Ways to Increase Working Capital

A business may wish to increase its working capital if it, for example, needs to cover project-related expenses or experiences a temporary drop in sales. Tactics to bridge that gap involve either adding to current assets or reducing current liabilities.

Managing working capital with accounting software is important for your company’s health. Positive working capital means you have enough liquid assets to invest in growth while meeting short-term obligations, like paying suppliers and making interest payments on loans. In contrast, negative working capital is a warning sign that a company may have difficulty keeping its head above water — and an ERP with strong compliance management improves business performance and increases financial close efficiency while reducing back-office costs, resolving delays and generating statements and disclosures that comply with regulatory requirements.


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