Although the phrase "working capital" is common in business and finance circles, it is often very misunderstood. Here's an example: if I asked you if you would rather own a business with a lot of working capital instead of a little working capital, what would be your answer? Most people would prefer the business with a lot of working capital. But the answer is not that simple, and, in many cases, smaller working capital actually indicates better management and cash flow generation. I will take a few paragraphs to discuss the two main reasons why working capital is misunderstood and then discuss the best measurement tool I know to monitor it.
WORKING CAPITAL DOES NOT EQUAL CASH
Working capital is often misunderstood for cash. Working capital is the difference between all of your current assets (cash, accounts receivable, etc.) and your current liabilities (accounts payable, accrued expenses, etc.). Notice that cash is actually only a part of this equation, and it is usually a smaller part at that. So, what in the world is working capital?
The easiest way to explain it is in terms of the number of days difference between when you pay for things and when you get paid. Here is a simplified example:
Cash goes out to pay for parts and labor to build a widget. After 10 days the widget is ready to be sold. It takes another 20 days to sell the widget to a customer on credit (net 30 terms). The customer pays early - in 25 days. The total working capital cycle is 55 days. Hence, the business needs to have enough "working capital" to fund this transaction until it gets paid.
WORKING CAPITAL IS A CYCLE OF CASH FLOW
Based on the example above, a business will need a certain amount of "working capital" to handle this 55-day cycle. But what if the company can improve its manufacturing process and get paid a little earlier, reducing its working capital days to 42? This means the company would need less working capital to fund its operations. Since most people confuse working capital for cash, we think a bigger number is better. But companies that run an efficient working capital cycle require lower working capital, the sign of a well-run and efficient business.
HOW SHOULD WORKING CAPITAL BE MEASURED?
There are lots of measurements that comprise working capital - days sales outstanding, inventory days, payables days, and more. Trying to look at all of these and make sense of the company's working capital progress is tough. So, we use a ratio that measures working capital days - one number to illuminate the entire working capital cycle. This puts the number into context and makes it easy to initially spot issues and challenges.
Very simply, the formula for working capital days is:
(Average working capital for a period/sales for the period)*(# of days in the period)
If I told you that you have a working capital balance of $500,000, it would be hard to understand if that was good or bad until you compare it to other periods of time in your business. If you are growing or shrinking, it becomes more difficult to know if your working capital cycle is accelerating or decelerating, or if you are squeezing more or less cash out of your operations. Here is a quick application of a real company's working capital days:
HOW SHOULD WORKING CAPITAL BE FINANCED?
Financing working capital is actually quite simple once we understand the working captal days ratio. At a company's maximum efficiency, there is a minimum number of days in its working capital cycle - maybe it is 15 days, or maybe it is 60 days. Regardless of the number, this part of working capital should usually be funded with permanent debt or equity.
I have yet to see a business that can function at their most efficient working capital cycle for very long. This is caused by spikes and drops in sales as well as new opportunities and new challenges that often arise daily. The days in the working capital cycle above this most efficient level are usually best financed with lines of credit or other revolving debt facilities. Sometimes it is financed with retained earnings or equity, but that may not be the most effective use of the firm's capital.
Working capital is a measure of the firm's ability to streamline its operations to generate cash as quickly as possible. When understood in this light, less is actually more. Business is, ultimately, about cash generation. The working capital cycle of a business can either gobble up more than its fair share of cash or it can be managed as an efficient cash flow system. If managed, it can become one of the company's most significant competitive advantages.
AUTHOR'S NOTE: This discussion assumes that the company keeps a target balance of cash and cash equivalents and either invests the rest into fixed assets or growth or distributes cash in excess of the target balance to owners or other operating entities. Target cash is frequently set at between 2-4% of annualized revenue, with many exceptions based on industry, growth/shrinkage rate,and several other factors.