What is Working Capital?

Alexa Cook: 

Hey guys, welcome to the Treasury Update Podcast, Coffee Break Sessions, the show where we cover foundational treasury topics and questions in about the same amount of time it takes you to drink your coffee. 

Alexa Cook: 

I’m Alexa Cook, consultant and strategic treasure and today’s host. So for today’s Coffee Break Session we’ll be taking a look at working capital, and aim to answer the question, what is working capital? I’m joined today by Craig Jeffrey, managing partner and founder of Strategic Treasurer. And let’s go ahead and get started. What is working capital? 

Craig Jeffery: 

The first coffee break session we talked about cash and I gave you two definitions of cash. And to be consistent and accurate, I’ll give you two definitions of working capital and then explain their difference. This is where people can find some insight into the process. So the accounting definition, or the banker’s definition of working capital is current assets minus current liabilities. And the treasury definition of net adjusted working capital, or shorthand working capital is accounts receivable plus inventory, minus accounts payable. So those are the two technical definitions of it. And I can explain more on either of those, why they came to be. 

Alexa Cook: 

Okay. Why don’t you start us off with the shorthand working capital definition. 

Craig Jeffery: 

So, the current assets minus current liabilities? The banker definition or the accounting definition? 

Alexa Cook: 

Yes. 

Craig Jeffery: 

Yeah, so that definition is driven for a particular reason, and that’s a quick measure, easy to calculate because it’s in the financial statements. You can get all of this from the balance sheet, and you can calculate this every time because everyone provides financial statements. And current assets minus current liabilities, that number should be positive. The size of that balance can show an organization’s ability to meet their obligations as they come due. Right? So if you have… Your current assets would be things like cash, accounts receivable, inventory, shorter elements of a couple other items on the chart of accounts there. Current liabilities are things that are due, accounts payable, some other liabilities are of a short term nature. So if you have more short term cash coming due than you have going out, that puts you in a positive position. The greater the access of current assets over current liabilities, the better your position is to meet those needs as they come due. 

Alexa Cook: 

Okay. So what would a good working capital ratio look like? Is it just the positive ratio where it’s maybe two to one, two being the current assets and one being your current liabilities? Or do you think 1.1 to 1 or? 

Craig Jeffery: 

1.1 repeating? No, it depends on the industry and usually a banker is looking at this to provide additional credit, or whoever they’re doing business with. So larger tends to be better, a bigger ratio or a larger sum of cash, because things happen or things don’t happen. Your suppliers may demand faster terms, your customers may pay you more slowly, and that creates a drain on your actual liquidity in terms of cash. So you just want to make sure you have a sufficient margin to weather different storms or periods. And then you have credit, like as we were just talking about, you have additional credit to help tide you over in those times where things don’t happen as they’re supposed to. 

Alexa Cook: 

Okay. So that leads into my next question, which is, is it better to have a large amount of working capital? And it sounds like it is, even if it’s just for a safeguard or like a rainy day fund. I don’t know if there’s anything you wanted to add to that though. 

Craig Jeffery: 

So that’s a good question, and since I gave two definitions typically with the accounting or the banker definition of current assets minus current liabilities you want that number to be larger. Right? You want your… And the bigger the better, within reason. An organization shouldn’t be sitting on massive, massive piles of cash because they’re not providing the return to those that own the company. If you can’t give them a better return than they can on their cash, return the cash. So more tends to be better than less but there’s limitations on that. 

Craig Jeffery: 

With that second definition, the net adjusted working capital where you have accounts receivable plus inventory, minus accounts payable. This is a factor, those things that are converting to or from cash. When you have accounts receivable plus inventory, minus accounts payable, do you want more or less? Well, you can get more by collecting slower, right? Accounts receivable goes up, therefore you have more working capital. In other words, that definition of working capital is you have more cash tied up in the regular cash cycle of the business. So collecting slower will increase it. 

Craig Jeffery: 

Well you don’t want it for that reason, but you may want more for accounts receivable if you’re trying to extend your sales without excess losses. Maybe you’re able to take market share with good margin, and so pouring your cash into accounts receivable may make sense. Same thing can be true with inventory. I’ve given examples before, you can reduce your working capital by not having any inventory, but you’re trying to decrease how much cash you have tied up in working capital that’ll do that. But now when someone tries to buy stuff, they can’t get it. It’ll take two weeks to get it, or some period of time, and therefore you lose sales. So the issue is do you want more or less? In both of those definitions optimizing it makes the most sense because there’s a number of factors. 

Alexa Cook: 

Okay. Finding that sweet spot. So then would negative working capital be a red flag or something to avoid? 

Craig Jeffery: 

So from the accounting or banker definition, you typically don’t want to go negative too much there. Unless it’s a seasonal activity, you have credit sitting to cover maybe a periodic lull where you have to pay a lot before a season, you have all this inventory and then it gets sold and gets converted to receivables. There might be a situation where that can be acceptable, but typically you don’t want to go negative with that definition. 

Craig Jeffery: 

On the net adjusted working capital, AR plus inventory minus accounts payable, it probably depends on the type of business. So, let’s say for example you’re an airline. When you buy an airline ticket, you pay for everything before you go. So they’re collecting everything upfront. Do they have a receivable? No, they don’t have a receivable from the people that are flying or the companies that are flying because they’ve paid everything up front. So they’ve created significant positive cash. 

Craig Jeffery: 

And so there’s some businesses where they can make a significant shift and negative or positive might reflect the organization. But many manufacturers for example, have inventory. Some organizations don’t really have inventory. It’s typical, let’s say, that your receivables are larger than your payables. For example, because if you’re making some goods or services, you’re paying for them, that’s flowing through payables. Hopefully you’re selling your goods for a lot more than you’re buying your materials that go into those goods. So your receivables should be larger than your payables. That’s a long way of saying it depends. 

Alexa Cook: 

Okay, so negative working capital might be a red flag, but doesn’t necessarily mean it is. 

Craig Jeffery: 

Yes. Yes. So I mean the key is… The issue is do you want more or less? Which was one of your first questions. That’s an interesting question because if we say you want to optimize it, we say that’s not really the right question. What’s the right mix of capital that you have? Is better than do you always want more or less? 

Alexa Cook: 

Okay, so then to recap on today’s Coffee Break Session on what is working capital, some of the key definitions and takeaways are working capital, which is our current assets over our current liabilities as far as the accounting perspective goes. Or you have the shorthand working capital, which is accounts receivable plus inventory, minus accounts payable. There’s not necessarily a specific red flag for when working capital is good or bad. It’s really sort of industry based or company-based. So a high ratio is not necessarily a great thing, and a negative working capital number is not a terrible thing. A lot of the importance or key points around working capital are going to vary between industries and companies. 

Craig Jeffery: 

That’s a fair way to put it. And with the things that we typically think about for working capital and cash, it’s not always bad to reduce inventory or reduce receivable. That may be a great way to expand market share, expand margin, especially if you have the strength to support it. 

Alexa Cook: 

Okay. Is there anything else you wanted to add or any final thoughts? 

Craig Jeffery: 

I have some stories about working capital if you want. 

Alexa Cook: 

Maybe next time. 

Craig Jeffery: 

Okay. I guess we are trying to keep these short. 

Alexa Cook: 

Thank you again for your time, and tune in in a couple of weeks for the next one. 

Craig Jeffery: 

Thank you. Alexa, 

OUTRO: 

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