Working Capital I

I am frequently surprised to hear business folks misuse this term. The error often made is in connection with startup expenses as in “It is wise for a new business to have at least six months of working capital in hand.”  What they are suggesting is to have enough funds to cover expected losses until the business becomes profitable. While the suggestion is a good one, operating expenses are an Income Statement event. Working Capital used correctly is strictly a Balance Sheet item.  And it is not one store of money as the misuse implies. It is simply the difference between two numbers from the Balance Sheet … Current Assets minus Current Liabilities.Slide45

The calculation result is an absolute number and can be either positive or negative. It is not a ratio. (We will get to ratios next.) If positive it represents the cushion or margin a business has toward paying its bills in the near term. In most cases Current Assets are comprised of cash (on hand and on deposit), accounts receivable and inventory. The latter two must be turned into cash (or liquidated) before their value can be applied toward any bills due and payable. There is always a degree of risk that some portion of receivables is uncollectable and some portion of inventory unsalable. If the business is in a trade that requires it to sell to customers on credit, the inventory has to be converted to a receivable and only then to cash, perhaps 30-45 days later.

Slide25This transition from cash to inventory to receivable to cash is called the “Trading Cycle” and will be discussed in another post soon. The more Working Capital a business has the more it can be considered liquid. However, like most things in finance it is all relative … relative to sales volume, relative to total assets, to total capital or equity, relative to previous periods and industry norms. Shown to the left is a graphic from my seminar showing the basic calculation. It is noteworthy that most companies present their financials properly, especially when under the supervision of a CPA.  But I have seen many statements that include bank debt in Long-Term Debt when in fact it is legally a current obligation.









Here again to the right is the calculation with real numbers from composite financials of the retail flooring business.The math is simple, and all it tells you is that at a given point in time this business had $140,300 in Working Capital. That’s good to know, but how much more valuable would it be to know that:

  1. It is more than last year and growing for three years in a row.Slide30
  2. It is better than most companies of the same size in the industry.
  3. The proportional relationship is strong, weak, or neutral.
  4. We will talk soon!


Douglas K. Steele


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