What is working capital?
Let’s first go through an intuitive example of what high working capital needs and low
working capital needs are.
Then we cover a definition of working capital, discuss the relationship between working capital
and cash, and calculate the working capital balance for two well-known multinational companies.
Let’s dive straight in!
Let’s imagine you operate a “buy-stock-sell” business in children’s toys.
You buy from your supplier, hold the toys in stock, then sell to customers.
Sometimes the product moves through your business at a nice steady pace, sometimes the process
has a bit more variability and the pace is a little slower.
What would you prefer as a business owner, assuming the pricing and profit margins are
the same between the two scenarios.
Would you vote for option A, where you pay your supplier cash on delivery, hold high
inventory levels, and grant customers 45 days credit before they need to pay you.
Or would you vote for option B, where you have 45 days credit from your supplier, work
with “Just In Time” inventory levels, and have your customers pay cash on delivery.
Please think about that and vote!
With option A, there is a high working capital,
that somehow needs to be financed by debt or equity.
With option B, there is a low working capital, reducing the need for financing.
With option A, cash flow and return on assets will be lower.
With option B, cash flow and return on assets will be higher.
The definition of working capital that we use in this video is: the total amount of
capital invested into your company’s operating cycle (day-to-day operations).
I believe this is the most useful way of looking at working capital.
What is the relationship between working capital and cash?
Let’s say that your children’s toys company decides on three actions: paying suppliers
quicker than before, holding more inventory, and granting customers extended terms.
This drives working capital up, and cash down, possibly triggering the need to go out for
more financing.
If however you stretch supplier terms (pay them later), achieve higher inventory turns,
and improve the collections of payments from customers, your working capital would decrease,
and as a result your cash would increase, possibly increasing the opportunity to pay
down loans, or pay dividends.
Two examples of how to calculate working capital for real-life companies.
First: 3M’s balance sheet at the end of December 2018.
I would say their working capital consists of the sum of accounts receivable, inventories,
and accounts payable.
Although you could argue that items such as prepaid expenses on the assets side, and accrued
payroll on the liabilities side, may also be considered “in scope”.
5 billion dollars in accounts receivable, plus 4.4 in inventories, minus 2.3 in accounts
payable, equals a net working capital of 7.1 billion dollars at the end of December 2018.
Microsoft at the end of their fiscal year 2018, which is June 2018.
Same items like at 3M: accounts receivable, inventories, minus accounts payable.
On top of that, due to the nature of the business, there is another significant amount in liabilities
called unearned revenue (or “deferred revenue”) that would normally be included in the working
capital calculation.
This is revenue for which Microsoft has been paid in advance, which is yet to be recognized
over the multi-year agreement, in other words a liability to customers for future services.
This has a big impact on the net working capital balance, which for Microsoft is actually a
negative number of 12.1 billion dollars.
A negative working capital balance is actually a good thing: both suppliers and customers
are financing your day-to-day operations!
In summary.
Working capital is the total amount of capital invested into your company’s operating cycle
(day-to-day operations).
Manage working capital well to improve your company’s cash flow,
and increase the return on assets.
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Thank you.