Working Capital

Corporate Finance
Mart Guasch
Fall 2015

Working capital: relevance

A firms working capital is the difference between current assets and
current liabilities.
Working capital = Current assets Current liabilities
(we will see alternative ways of computing working capital later)
Working capital is a key part of the analysis of the financial
management of a firm: it is a main step in determining the optimal
capital structure for a given firm and it is one of the components of the
analysis of any investment project.
Indeed, working capital can be understood as an asset or an
investment which is part of any project/firm and which, therefore, has
to be financed.

Working capital: relevance

There are no general ideal or target values: the value of working
capital depends very directly on the firms line of business and type of
product, established ways of payment to suppliers and collection from
customers, etc.
A sufficient level of working capital is essential to ensure the
stability of a firm: it makes sure that all short-term liabilities can be
faced with current assets.
From a financing viewpoint, working capital is the part of current
assets financed by long-term forms of financing. This can be easily
seen in the next picture.

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Working capital
Assets

Fixed
Assets

Current
Assets

Equity + Liabili8es

Assets

Equity

LT
Debt
Current
Liabilities

Working
capital

Equity + Liabili8es

Fixed
Assets

Equity

Current
Assets

LT
Debt
Current
Liabilities

Working capital: Alternative way to look at

WC
Working capital can also be calculated by subtracting fixed assets from
equity and long-term liabilities.

Working capital = Equity + Long-term liabilities Fixed

assets

Working capital = Permanent financing Fixed assets

Working capital: relevance

As a general rule, working capital should be positive: a negative
working capital would mean that fixed assets are being financed with
short-term liabilities, which could increase the probability of defaulting
on payments as the latter fall due.
However, there are firms which have negative working capital
without it being a problem. The reason is that they have a collection
period shorter than the payment period (e.g. supermarkets).

Working capital: relevance

Lets see this with an example. Imagine a firm which collects cash in
30 days but pays its suppliers in 90 days. The nature of the business
does not require investment in stock or the carrying of a permanent
cash balance. The balance-sheet looks like:
Assets

Liabilities + Equity

Fixed assets

40

Equity 20

Debtors

20

Creditors 40

Total

60

Total 60

Working capital for this firm is negative:

Working capital = current assets current liabilities = 20 40 = -20
or WC = permanent financing fixed assets = 20-40 = -20

Working capital: relevance

But, isnt the firm with negative working capital in danger of not
meeting its liabilities as they fall due? In this example the firm would
receive 20 and pay only 13 in any one-month period.
Since the collecting period is 30 days, and the payment period is 90 days, in the
coming month the business will realise the total debtor balance (20) but only one
third of the debt with suppliers will be paid (13=40/3). This situation is commonly
found in retail firms or insurance companies.

If the periods of cash collection and payment, and other

characteristics, remain constant, the firm is in no danger of
defaulting on its obligations even though it has negative working
capital.

Working capital: relevance

Thus, in order to establish an ideal capital structure for a business, it
is not enough to compare current assets to current liabilities: the
analyst has to know the length of collection and payment periods,
which include some understanding on:
Operating cycle
Cash cycle

In any case, the general recommendation is that a business should

normally have a positive level of working capital in order to avoid
liquidity problems.

The need for working capital: operating

and cash cycles
The operating cycle is the number of days between the purchase of
raw materials and receipt of payment from the customer.
This includes, therefore, the length of the production process, storage of stock
and credit period taken by the customer.

The cash cycle is the gap between the initial investment of funds in
purchases of raw materials (i.e. raw materials days creditors days*),
and receipt of payment from the customer.
* In the cash cycle, creditor days are subtracted because they represent a period in which
the company is financed by its suppliers for free.

The need for working capital: operating

and cash cycles

Operating cycle = Raw materials days + production days +

finished goods days + debtors days

Cash cycle = Raw materials days creditor days + production

days + finished goods days + debtors days

CASH CYCLE
R.M. purchase

Suppliers
payments

Payment period Goods in progress

period
Raw materials
period

Customers
payments

Sales

Finished goods
period

Collection period

Cash cycle
Opera8ng cycle

The need for working capital: operating

and cash cycles
Example 1. A firm provides the following data:
Number of days of stock in the warehouse = 28 days;
Number of days of production = 20 days;
Number of days of finished goods = 30 days;
Supplier payment period = 15 days;
Client collection period = 60 days.
Operating cycle = 28 + 20 +30 +60 = 138 days
Interpretation: this firm takes 138 days between reception of the raw
materials and collection of cash from clients.
Cash cycle = 28 + 20 + 30 15 + 60 = 123 days
Interpretation: suppliers provide 15 days of automatic financing, so
the firm only needs to find extra financing for 123 days.

Period ratios: Turning days into

1) Raw material days:

Raw materials days =

Stock of raw materials

365
Annual purchases

This ratio can be compared with the average number of days that
providers take to supply raw materials: both should be similar to each
other, depending on the firms stock management policy.
2) Production days:

Production days =

Work in progress
365
Annual production costs

Period ratios: Turning days into

3) Finished goods days:

Stock of finished products

Finished goods days =
365
Annual cost of sales
We should subtract selling expenses from the cost of sales, since these
are costs not included in the value of finished goods.
4) Client days (collection period):

Collection period =

Trade receivables (Debtors/Clients)

365
Annual Sales

5) Supplier days (payment period):

Trade payables (Creditors/Suppliers)

Payment period =
365
Annual purchases

Actual versus required working capital

The Actual working capital = CA CL
However, some CA or CL are not really operating (e.g. short-term financial
debt, financial assets, s/t deferred tax assets)
The Required working capital is the level of WC needed by the firm in
order to finance its operating activities (only operating accounts).
Required WC = Operating CA Operating CL= Stocks + Acc Rec. + Cash AP
Thus,
Actual working capital Required working capital = WC deficit / surplus
- If Required WC > Actual WC: WC deficit
- If Required WC < Actual WC: WC surplus

Calculating Required WC by estimating

days of each WC item
Required investment in raw materials
+ required investment in intermediate goods
+ required investment in finished-goods
+ required credit given to clients
- Credit provided by suppliers
+ Minimum cash required *
Working capital required
* We can compute the minimum required level of cash:
a) Using some average level of cash holdings of other competitors (as a
function of assets, for example) to compute the minimum cash requirement.
b) Assuming a number of supplier (and other creditor) days that the company
would want to be able to meet with its cash holdings. For example, we should
have enough cash to cover 30 days worth of payments to suppliers. Then you
can directly convert this into the minimum level of cash required.
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