What is Working Capital?

Simply put, working capital is the difference between an organization’s current assets and its current liabilities. Also referred to as net working capital, it is commonly used to measure an organization’s liquidity and short-term financial health.

Understanding the balance between current assets and current liabilities is essential for efficient working capital management. Assets considered include cash and cash equivalents (e.g., money market accounts), accounts receivable, inventories of raw materials, as well as finished goods and prepaid expenses. Liabilities include accounts payable; accrued wages, taxes and dividends; unearned revenue and debt. By comparing an organization’s assets and liabilities, treasurers can get a better understanding of the organization’s level of liquidity. The formula is:

Working Capital = Current Assets – Current Liabilities

Working Capital Metrics

PART 2

Working Capital Metrics

If you are working in treasury, there are fundamental metrics you need to be familiar with. These metrics are used to assess the effectiveness of working capital management, which will tell you what the firm’s default risk is — the risk that the firm won’t be able to pay its creditors. 

These metrics are also used internally to assess the company’s performance, adjust payment terms, forecast cash flows and manage liquid resources. When you understand the company’s working capital position, and its funding requirements, then you as a treasurer have the information you need to make strategic decisions that include short-term investments, borrowing, credit terms and resource allocation. 

There are a few things you will want to keep in mind when analyzing the metrics. First, there is no right or wrong number for a particular metric. Second, determining the metric’s trend is important, as is understating the factors underlying the trend. And finally, remember that metrics vary by industry and by country, so be sure to compare like to like — same industry, same country. 

The fundamental working capital metrics are:

Net Working Capital (NWC) is figured by subtracting the total current liabilities from the total current assets. It is never a ratio, but rather an absolute measure. What the NWC tells you is, if all the company’s assets were converted to cash, it would have X amount more than is needed to pay off its current liabilities. 

For example: $8,000 (current assets) - $3,400 (current liabilities) = $4,600 net working capital.

Current Ratio is figured by dividing the total current assets by the total current liabilities. What this figure tells you is the degree to which a company’s current obligations are covered by its current assets. Calculating the working capital ratio (aka current ratio) provides insights into a company’s short-term financial health, indicating its ability to cover short-term liabilities with short-term assets.  

For example: using the same figures as above, we would have $8,000/$3,400 = 2.35. What this tells you is that the company carries $2.35 of current assets for every $1 of current liabilities. The higher the current ratio, the lower the default risk for creditors.

Quick Ratio (also known as the acid test ratio) is figured by figuring the sum of cash, short-term investments and accounts receivable and dividing that number by the total current liabilities. Just like with the current ratio, the higher the quick ratio, the lower the risk for creditors.

For example: $1,500 (cash) + $1,300 (short-term investments) + $1,700 (A/R) / $3,400 (current liabilities) = 1.32

The company has $1.32 in liquid assets for every $1 of current liabilities.

Days Cash Held is figured by dividing cash by operating expenses minus noncash expenses, divided by 365: 

Days Cash Held = Cash / ((Operating Expenses – Noncash Expenses) / 365)

What this metric tells you is the measure of the company’s liquidity, or when the company will run out of cash, assuming operating expenses are paid on time and no additional revenue comes in. Of note, noncash expenses such as depreciation are excluded from the calculation. 

For example: $1,500 (cash) / [$4,000 (operating expenses) - $200 (noncash expenses) / 365] = 144 days

However, this 144-day figure is not clear cut. The operating expenses are taken from the income statement, and are therefore treated as an average in the calculation. You would need a more detailed assessment of when operating expenses are due to achieve a more accurate figure. For example, if a major expense is due soon after the balance sheet date, the days cash held figure may be masking a potential cash shortage. By that same logic, if most major expenses are due shortly before the next balance sheet date, then days held cash would be understating the company’s cash position.   

The Cash Conversion Cycle

 

PART 3

The Cash Conversion Cycle

The cash conversion cycle (CCC) tells you the time required to convert cash outflows associated with production into cash inflows, i.e., accounts receivable. It is figured as the average age of inventory (days inventory) plus the average age of A/R (days receivables), minus the average age of A/P (days payables). 

What is of note with the CCC is that it is critical to the monitoring of how long it takes to sell inventory, the time between when a sale is made and cash is collected, and the actual disbursement period. 

Days Inventory (DI) is figured dividing the inventory by the cost of goods sold (COGS) and multiplying that by 365. The figures for the inventory and COGS are taken from the balance sheet and income statement. 

For example: $2,600 (inventory) / $9,200 (COGS) x 365 = 103.15 days

The value tells us that it took the company an average of 103.15 days to sell its inventory. Of note: a shorter DI frees up working capital. 

Days Receivables (DR) is figured by taking the period’s ending value for A/R and dividing it by revenues, then multiplying that by 365. DR tells you the number of days of dales held in the form of A/R. 

For example: $1,700 (A/R) / $15,000 (revenues) x 365 = 41.37 days

The value tells us that the company held 41.37 days of sales in A/R during that period, or the number of days required to convert a sale into cash inflow. 

Days Payables (DP) is figured by dividing accounts payable by the COGS, and multiplying it by 365. 

For example: $1,600 (A/P) / $9,200 (COGS) x 365 = 63.48 days 

This value tells you that the company took an average of 63.48 days to repay A/P. Of note: be sure to compare the DP to the trade credit terms provided by suppliers. 

Calculating the CCC

Now that you have the DI, DR and DP, the CCC is then calculated by subtracting the DP from the sum of the DI and DR. 

For example: 103.15 (DI) + 41.37 (DR) – 63.48 (DP) = 81.04 days

What this value tells you is that, on average, 81.04 days passed from the time the company disbursed cash until it recovered cash from a sale during the prior year. 

How can you improve the CCC? 

  • Shorten the DI through careful purchasing and production schedule, and by removing excess finished goods from the inventory.

  • Shorten the DR by monitoring customer payment habits, reducing delinquencies, adjusting payment terms and using faster collection channels.

  • Increase the DP by effectively managing A/P through the acceptance of supplier discounts only when it works in your favor, i.e., don’t pay earlier than is required.

 

Cash Turnover

The cash turnover ratio refers to the number of cash conversion cycles a company experiences in a given fiscal period, typically a year. It is figured by dividing 365 by the CCC.

For example: 365 / 81.04(CCC) = 4.5 times

What this value tells you is that it takes 81.04 days to recover each dollar invested in the production process, and that the recovered dollar was spent again 4.5 times in the last fiscal year. With this information, you know how many times you can spend, collect and re-spend a dollar in an accounting cycle. If the number increases, then the company is using its working capital more efficiently, and of course the reverse is true if it decreases.

Managing Working Capital

 

PART 4

Managing Working Capital and the Cash Conversion Cycle

The importance of managing cash and working capital cannot be overstated; without them, organizations simply cannot exist. Yet, when targeting growth, too many organizations focus on trying to increase sales or reduce supplier costs, while ignoring the potential benefits of efficient working capital management.

A renewed focus on internal processes can unlock working capital “trapped” in the cash conversion cycle (CCC) — the time required to convert cash outflows associated with production into cash inflows through the collection of accounts receivable. It is calculated using the following equation:

Cash Conversion Cycle = Days Inventory
Outstanding (DIO) + Days Sales Outstanding
(DSO) – Days Payable Outstanding (DPO)


For help calculating the CCC, download AFP’s Payments Guide to Unlocking the Cash Conversion Cycle. 

These funds are then available to be recycled back into the business. Freeing this cash has a direct impact on the business's bottom line. It allows the business to grow because working capital that was previously being used to fund an inefficient process can now be invested to help the organization achieve its strategic objectives.   

Treasury can influence the CCC in two significant ways. First, treasury can introduce, or help with the introduction of, more efficient ways of processing the data and payments associated with the physical supply chain. This is where digitization plays a major part by providing more opportunities for treasury to interrogate data across all three elements: suppliers, inventory and customers.

Second, treasury can help other parts of the organization understand the financial implications of the business decisions they make. Treasury’s influence is growing, which is due in part to a trend toward the centralization of policy setting and the emergence of technologies that allow treasury to identify and share more detailed insights with the rest of the business. By focusing on the individual elements of the CCC, treasury can help identify potential efficiencies.

Cash Flow Forecasting in Working Capital Management

PART 5

The Role of Cash Flow Forecasting in Working Capital Management

Cash flow forecasting provides a clear picture of a firm's liquidity and financial health, making it a critical task of working capital management. Here’s how it works: Effective working capital management hinges on the firm's daily operating activities, such as paying for goods and services and making and collecting on sales. These activities generate various working capital accounts, including inventory, A/P and A/R. The process of forecasting cash flows allows businesses to predict the timing and amount of cash inflows and outflows associated with these accounts, which means they can anticipate and address potential liquidity issues and optimize their cash flow.

Further, by understanding the relationship between working capital management and cash flow forecasting, treasurers can achieve significant cost savings and support their organization’s strategic planning. Optimizing processes like procure-to-pay and order-to-cash helps treasurers negotiate better terms with suppliers and accelerate cash collections, thereby avoiding late payment penalties and reducing the need for short-term borrowing. 

When treasurers understand the implications of cash flow forecasting, they’re able to make informed decisions about short-term investments and manage financing needs, whether by investing surplus cash or addressing shortfalls through credit lines. Additionally, effective management of A/R and inventory reduces financial risks such as bad debts and obsolescence. 

This approach, underscored by precise cash flow forecasting, not only mitigates financial risks but also ensures the company has the liquidity needed for strategic initiatives such as capital expenditures, mergers and acquisitions.

Effective Liquidity Management

Liquidity is crucial for making important business decisions, such as investing in new projects or securing loans. Unlike a static cash forecast, a dynamic liquidity planning model includes various cash flows and allows real-time adjustments.

Successful liquidity management provides a clear view of the organization's spending, cash reserves, liabilities and resources. Effective liquidity management ensures the company can meet its short-term obligations while maximizing investment opportunities. 

The benefit to treasurers is that they can use liquidity planning to access unused credit lines or issue debt, providing the company with needed cash. However, it's important to consider the potential impacts of such moves on credit ratings and loan covenants. That said, liquidity planning helps model these potential consequences, providing insights for CFOs and treasurers to manage it effectively.

 

Influencing the Bottom Line

PART 6

Influencing the Bottom Line

Taking action to improve the efficiency of the accounts receivable cycle can result in significant improvements in DSO. Similarly, changing processes within the accounts payable cycle can help the organization improve visibility over its cash and, consequently, manage liquidity and working capital more efficiently. 

Treasury cannot directly control inventory in the same way, but the department can offer insight to the wider business to help it manage inventory more efficiently. In the same way, treasury can offer advice to help the business understand how procurement and sales decisions affect working capital and, therefore, influence the bottom line.

 

Related Working Capital Articles

Improving Payment Processes and Working Capital Improvements Are the Most Challenging Tasks for Treasury Professionals

Improving payment processes and working capital improvements are the two most challenging tasks facing treasury professionals today, according to the 2022 AFP Strategic Role of Treasury Survey, supported by Marsh McLennan.

Cash Conversion Cycle: What Is It and How Can You Improve It?

All organizations know the importance of managing cash and working capital; without them, organizations simply cannot exist. Yet, when targeting growth, too many organizations focus on trying to increase sales or reduce supplier costs, while ignoring the potential benefits of efficient working capital management.

Three Keys to Treasury Optimization

In a recent webinar, we explored the three keys to treasury optimization, which contributes significantly to a team’s effectiveness as a strategic business partner to its organization, C-suite and board of directors. Here we provide you with some basic tenets of each key, as well as some practical examples of how these keys were implemented.