Working Capital – A Simple Guide
Working capital - a simple guide
This simple guide to working capital was updated in November 2019.
Working capital is arguably the most important tool in every business’s financial toolkit.
We work in a business landscape that is constantly evolving. Operating costs are rising, and as opportunities are presented, the ability of any business to improve free cash flow, reduce costs and strengthen supply chain relationships is becoming profoundly important.
Clearly, businesses need access to affordable financing – and just as clearly, businesses must take a strategic approach to optimising their cash position and increasing the working capital to create a stronger, healthier and far more efficient supply chain.
A more useful working capital definition
Working capital is one of the basic metrics used to evaluate a company’s financial health. It is looked at by many as a short-term finance driven number (although there are a few issues with this calculation when considering liquidity, so many CFOs treat the figure with understandable scepticism).
(current assets) – (current liabilities)
More importantly for business growth, working capital is the vital tool the senior team have at their disposal when important decisions need to be made regarding future investments, purchases and decisions to support the business’s next stage of growth.
From a capital perspective, businesses need financing that is appropriate to their asset conversion cycles. Put more simply, the business’s ability to finance new initiatives is dependent on the conversion of assets into cash.
Businesses typically make much better, stronger and more proactive decisions related to growth when they understand the importance of the timing of the asset conversion, and take proactive steps to ensure that working capital is available when it is needed.
Working capital in practice
As an example, consider a company whose sales are increasing (both seasonal or as a long-term trend). What happens on the balance sheet? How are the asset account balances affected?
- Neutral or Declining
- Increasing; required to support sales volumes
Accounts Receivable Account
- Increasing; more customers on credit terms
Fixed Asset Accounts
- Stable; may increase dependent on type of business
The rate and scale of changes to asset accounts depend on the type of growth.
Businesses that experience seasonal highs and lows have different working capital challenges from those that operate with a long term cash deficit.
Retail businesses, for example, often experience a huge working capital trough in the autumn, and a cash surplus in December and January. In contrast, a business that is involved in huge commercial construction projects is perpetually challenged with contractors requiring payment long before properties are available for sale or occupation.
Business growth requires working capital
Growth needs working capital – pure hard cash – to support it. A company with financing that is flexible enough to support changes to its asset accounts is in a position to grow.
A company that is slave to its contractors, constantly struggling to improve its working capital situation, is disempowered. They may be unable to make the right, forward-thinking, strategic plans for growth.
If the asset conversion cycle is long and stable, long-term financing is needed. Conversely if the asset conversion cycle is short, short-term flexible financing is needed.
The difficult question though is “how much long-term financing (stability) and how much short-term financing (flexibility) is ideal? In theory, unlimited cash would be ideal – but the reality is that for most businesses, this is unrealistic and potentially very expensive to finance.
Add in the fact that asset conversion cycles tend to overlap, and this balance is challenging to say the least.
Working capital – how much is really enough?
Traditionally, credit providers place importance of the level of working capital. But how much is enough? Unfortunately, this is a bit like asking “how long is a piece of string?”.
An old definition of working capital – not the one used on Investopedia – but one we still think is correct would be:
Working capital is the amount of long-term financing used to finance current assets.
In every business, a portion of the current assets, inventory and accounts receivable, simply don’t convert to cash. Even at the lowest point of a company’s business cycle, these accounts will retain positive balances. And the company should match debt repayment to the rate at which current assets convert to cash.
At Woodsford TradeBridge, we work on the principle that, as a ratio of these current assets are “long-term”, the company should finance this ratio of current assets with long term working capital finance. In our business for example, we offer unsecured supply chain finance facilities, funded with our own money to strong growing businesses in wholesale, retail and construction.
Introducing the concept of working investment
Cash flow timing differences and growth in assets put pressure on every growing business. And in this way, business growth inevitably impacts working capital.
Working Investment is a simple way to calculate the financing requirements of the business needed to support a cash flow timing difference.
Working Investment is calculated as
Inventory and Accounts Receivable – (Accounts Payable + Accrued Expenses)
A simple method of getting a feel for your business’s Working Capital number is:
- Take the highest point of Inventory and Accounts Receivable assets accounts
- Estimate potential shrinkage at high point of these accounts, deducting old inventory and bad debt
Working Capital Required = Low Point Working Investment + High Point Shrinkage
This is not an exact science. Business growth predictions are a useful addition, but nonetheless, this is a good guide to where a business should be.
Working capital and the role of supply side financing
Woodsford TradeBridge offer supply side financing applications which address these pressures related to working capital. We offer businesses incremental working capital of between £500,000 and £10m, giving the business the headroom needed to make the right decisions to support business growth.