Working Capital Management – Fundamentals

Working capital management is a function of finance whereby management ensures adequate cash is available to meet operational needs over the typical working capital cycle. The underlying elements of working capital management include 1) understanding the different forms of current assets and current liabilities and their corresponding cash cycles; 2) recognizing the relationships of production and sales flow; and 3) planning the inflows and uses (outflows) of cash.

The head of finance or the person responsible for this management should be sophisticated in business and experienced with the company’s operations. In small business, this function is typically performed by the owner or the Certified Public Accountant for the company. This article explains the first of these three elements and the various attributes involved. There are several examples provided to assist the reader in understanding these underlying concepts. If not fully comfortable with the basics of working capital, please read the following in order to fully grasp the fundamentals of working capital:

* Working Capital
* Current Ratio
* Quick Ratio
* Working Capital Cycles  

This article is long which correlates to the subject matter at hand. Please take your time and take a break as necessary.

Understanding the Forms of Current Assets and Current Liabilities

By far the easiest and best form of any asset is cash. The flexibility and acceptance of cash makes this particular asset the most coveted. On the flip side, any liability with flexible payment terms is preferred over the more rigid requirements of some liabilities. Consider for example the difference between a line of a credit and a note payment.

* Line of Credit  – A bank instrument allowing the customer (borrower) to borrow money at will. In addition payments are made as deemed fit by the customer. The instrument has a drop dead date for full payment. Most often the agreement is for one year. This type of instrument provides maximum flexibility and has no punitive repercussions.

  * Note Payable – At the other end of this financial relationship is a note payment requiring regular monthly payments. Failure to pay on time triggers punitive damages and possible repossession of physical assets.

All other liability cycles exist between these two extremes.

The following are two tables identifying the more common flexibility attributes of the various current assets and current liabilities.

Current Assets                                    Flexibility Attributes
Cash                                                       N/A (Maximum)
Accounts Receivable                             Commonly 30 days, but is industry based
Inventory                                               Ideally less than 30 days
Prepaid Expenses                                  None due to amount of time to request and receive refund

Current Liabilities
Accounts Payable – Production             Generally 30 days to pay
Accounts Payable – Operation               Varies but never exceeds 30 days
Credit Cards                                           14 – 21 days
Accrued Payroll/Expenses                    Triggered by event/specific date
Accrued Taxes                                       3 – 15 days depending on authority
Line of Credit                                        Highly flexible
Current Portion of L/T Debt                  Less than 30 days; 1/12 of balance

As an owner or finance manager you must fully grasp the underlying elements of each of these eleven different cash cycles (both inflows and outflows) to understand their respective timing attributes and the impact each has on cash. The following subsections walk through ten of these cycles (excludes cash) and highlights their unique elements. Examples are provided for clarity and there are more resources for each available on this site.

Accounts Receivable

Even with the best accounts receivable management processes there will still be large sums of amounts owed to the company from customers. The key to understanding payment cycles is to look at the past and use history to track the future inflows. In a typical large volume invoicing operation, those invoices generated today will be paid 23 to 30 days from now. Therefore, those invoices generated three weeks ago will get paid this week. On average about 20 – 25% of the accounts receivable balance will be paid this week. Another 20 – 25% next week and so on. Some weeks may see more, while others will obviously be less.

Naturally this isn’t true with every company. Those in project based operations will have greater dispersions of time between payments and significant inflows of cash when payment is received. The volatility of accounts receivable is much higher for project based operations.

This is also true for limited customer based operations. Those with very few customers but significant volume per customer must go beyond simple accounts receivable cycles and understand their customer business cycles. Here are a couple of examples:

S&B Electric Inc.

In this electrician’s business he provided services to about a dozen different customers. Some were new home contractors, one was a commercial shopping center builder but his biggest customer was a hospital network. Over 65% of his sales were generated from the hospital. Over time he learned the hospital used three different pools of funds to manage the operations of the hospital network. * New Construction – Any new electrical construction came from this pool, funds were released periodically and therefore were extremely slow for payment; sometimes as long as six months. * Accreditation – To comply with national standards, X-Ray and MRI units required modernizing every so many years. This hospital had upwards of 100 X-Ray rooms and a dozen MRI units. Funds were controlled by an entirely different department and payment cycled from 120 days to upwards of 180 days. * Maintenance – This form of electrical work had regular cycles of 30 – 40 days for payment.  

Foster Care Services

A non-profit organization provided foster care services for 20 different social services departments. Each social services department managed their respective program differently. Each foster care case had several different fees paid by different funding sources making payments sporadic and often partial in nature (one or two of the funding sources may not yet be available). Some customers (social services departments) paid in a timely fashion, most were consistently tardy. For success, the foster care non-profit spent time with each of the 20 customer contacts to help facilitate and expedite payment. By modifying the documentation process, average cycle time decreased from more than 60 days to less than 30 days; most were paid within 25 days. Better yet, no social services department had an unpaid invoice older than 90 days.

Sometimes accounts receivable cycles are tied to contractual performance issues. Understanding contract law and the respective terms of the contract with the customer is tantamount to understanding payment timing.  Often the receivables department doesn’t understand why no payment has been received until communication with the customer identifies the unresolved issue in the contract. Customers are reluctant to pay until 100% satisfied. Again the accounts receivable management  process pinpoints the problem early on in the cycle.


Unlike accounts receivable, inventory is lower or further out in the overall working capital cycle to ultimately become cash. In general inventory is product available for sale. In a traditional exit payment retail environment where cash is paid for the product, the inventory to cash cycle is short. Think of a convenience store where some products turn quickly like cigarettes and beer. Others have longer turnover periods like diapers or cans of fruit on the shelf (people buy these products at the discount store).

To go beyond the retail environment, think of business to business models and the turn rate involved with their inventory. Here are some examples:

 Dominion Metal Fabrication  – The particular company made tank systems for holding liquids. The specs for the particular product dictated the type of steel used and its wall thickness. The raw materials inventory (steel, metal frames, plates, flanges, bolts, nuts, gaskets and valves) were ordered and received. The raw materials are then assembled into a finished product.  This entire inventory cycle may take upwards of 30 to 60 days depending on the tank’s specifications.After testing, inspection and acceptance by the customer, it is shipped to the customer. Once the customer receives the tank, Dominion invoices the customer. The invoice amount includes three core components:1) The cost of materials, 2) Cost of engineering and labor to construct, 3) Profit.   

Now the inventory changes from a physical item into an accounts receivable (paper) balance. Assuming 30 days to get paid, the entire inventory to cash cycle takes upwards of 90 days.

In some industries, inventory to cash can take years!

Bourbon Distillation

One of the beloved American made spirits is bourbon. It is made with corn mash and usually rye. The initial ingredients are relatively inexpensive. The real cost of the inventory is inserting the liquid into the special made barrels and storing for upwards of 10 years. Imagine the cost of warehouses to store large quantities of barrels for such extended periods of time. From start to finish, inventory to invoice, is a little over 10 years.

What is important when evaluating inventory is understanding the turnover time for inventory. Naturally, the longer the cycle the greater the need for working capital. In addition, volatility of business performance increases too.

Prepaid Expenses

The particular asset is an anomaly in accounting. Basically the company purchases particular services or products in advance and then amortize this cost over a 12 month period. Here are some of the more common prepaid expenses:

A) Insurance – Insurance is often prepaid based on the agreed contract with the underwriter, especially property insurance for real estate intensive businesses such as condo associations, apartment complexes, office buildings and commercial facilities. Often the mortgage document requires insurance paid in advance for at least 12 months.
B) Real Estate Taxes – Very similar to property insurance, many counties require tax payments in a prepaid format and not post pay.
C) Software Packages – Many licenses to use software packages require an annual upfront payment. The business then amortizes this payment out over the 12 months of use.
D) Data Storage – A relative newcomer in business, data storage such as databases or cloud storage require prepaid contracts for a year. This includes such fees as the website domain and website space. Just as with the other forms of prepaid expenses, the cost is amortized over 12 months.

As this pertains to working capital management, it is best to omit this particular current asset from the formula for several reasons:

  1) Technically it is a prepaid liability; i.e. the particular expense is automatic and rarely a one time event. Think of all four examples; they are mandatory every year.
  2) The asset value can not be turned into cash, the cash has already been utilized to pay for the particular expense.
  3) Even if the business decided to retrieve the cash, say they renege on the insurance policy, the penalties involved and the increased risk would far exceed any value derived from the use of the cash.

Accounts Payable

This account in the current liabilities section of the balance sheet has two sub accounts.  The first and most commonly used is accounts payable for production.  Those materials or products used to make or act as the final product for sale to the customer.  Typically the suppliers are referred to as vendors or subs.

The bills received for materials or product typically have 30 day grace periods for payment.  Sometimes vendors allow longer periods of time to pay especially for seasonal products, specialty items or volume purchases as illustrated below.

RV Dealership

RV dealers customarily buy an entire year’s worth of major parts and recreational accessories at one time. In general they’ll purchase 60 to 70% of their entire stock just prior to spring for demand during spring and summer. Some of the expensive items like air conditioners, electronics, appliances and suspension kits have extended payment terms. Instead of 30 days, the vendors allow payments of one fourth of the balance each month over four months. The lesser expensive items are paid within the traditional 30 day period.

The second type of accounts payable is operational expenses, those costs for general overhead and selling. These include the following:

  1) Rent                                            6) Utilities
  2) Office Supplies                           7) Maintenance and Cleaning
  3) General Insurance                       8) Professional Services
  4) Worker’s Compensation Ins        9) Technology
  5) Advertising Costs                      10) Banking/Costs of Capital

In general most of these bills demand payment in less than 30 days but recur every 30 days; think of rent and utilities. Sometimes the bill isn’t recorded until the middle of the month but is due at month’s end.

As a business manger, although the bill may not be recorded, it should still be considered in management of working capital.

Credit Cards

Credit card companies send statements and not bills. There is an entirely different process to manage credit cards as explained in Lesson 42 – Purchases Via Credit Cards. There is give and take using credit cards in business. Flexibility increases because there is no 100% demand for the balance due; however, any balance unpaid in the monthly cycle carries a higher interest rate cost than a line of credit account.

Accrued Payroll Expenses

During each payroll run and employer also includes, by accruing certain benefits, costs associated with the payroll. These costs include:

  * Gross wages value of vacation earned
  * Gross wages value of sick leave earned
  * Employer/Employee contribution to a retirement plan
  * Employer amounts owed for life insurance, dental, vision insurance, etc.

Notice that none of these expenses are tax related?

This is because payroll and other taxes are accrued as a liability in a separate liability account (see below).

Each of the above individual expenses have different payment cycles. Often insurance products are paid in advance of coverage. Others are triggered by certain events including illness and vacation times each year (summer and holidays). When addressing payment times, the owner/finance manger should use tests of reasonableness to determine how much cash will actually be needed over certain periods of time.

Accrued Taxes

The accrued taxes are divided into three distinct groups:

A) Income
B) Payroll
C) Operational

The first two are self explanatory. The last group includes the following:

  * Sales and Meal Taxes
  * Revenue and Licensing Taxes
  * Franchise
  * Certifications, Transportation Tags/Registration and State Authority Licenses
  * Property, Real Estate and Asset Based Taxes

Each of these taxes have different cycling times. For example sales taxes are customarily due monthly by a certain date; whereas Federal Income Taxes are paid quarterly.

Line of Credit

Of the various types of bank loans [link to article – Various Types of Bank Loans] the line of credit is the most flexible. Often extended to well established business operations or high FICO score owners, lines of credit act as a cushion or a safety net during leaner times. It is very similar to a credit card except it is used to provide cash. Some businesses use it as a funding tool or primer to start a long-term contract; or to purchase product for a seasonal sale. Below is an example of a line of credit use.

Prestly Lawn Equipment

This small business has two divisions of sales in the customized yard and small farm equipment supply industry. One division services small engines and minor repairs for landscaping equipment. The other division sells equipment including riding lawnmowers, chain saws, augers, weed eaters and small trailers. Just prior to spring the company orders over $100,000 of equipment and sells this equipment over a very intensive three month period (April – June). The line of credit is used to take advantage of bulk discounts and early pay incentives. As the equipment is sold, the line of credit is paid back so that it is completely paid back at the end of June. The entire cycle is five months start to finish.

Typical lines of credit are tied to the personal financial worthiness of the owner. It is a recourse loan, thus allowing for more flexibility.

Current Portion of Long-Term Debt

Under generally accepted accounting principles (GAAP) long-term debt  is divided into two distinct components on the balance sheet. The primary component is the remaining principal balance less the principal balance due over the next 12 months. The second component is classified as current and it is the principal portion of long-term debt due during the next 12 months. The formula looks like this:

  Total Long-Term Debt Principal Balance =  A) Principal Balance Due During the Next 12 Months (called the current portion)
                                                                         B) Principal Balance Due More Than 12 Months Out (long-term portion)

This means this particular account includes all the respective 12 month principal payments for all the long-term notes. In general, you should expect 1/12 of this total will be needed over the next 30 days. In effect there are 12 sub cycles within this dollar value.

First Caveat to this Concept:  Some notes have a call provision ( a tool to force refinance) at some point in the note. When this call provision value comes due within the next 12 month period, i.e. it becomes current; the entire remaining principal balance for that note is reclassified as current. It is relatively easy to spot because the current portion of long-term debt balance will seem to be unreasonably high. This greatly affects working capital management. Naturally the best solution is to refinance the note.

Second Caveat to this Concept: Interest amounts for these note payments are NOT  included in the current portion of long-term debt. Current portion is strictly limited to the principal portion of debt payments. When evaluating working capital management, keep this interest portion of debt service in mind.

Summary – Working Capital Management

Working capital is defined as all current assets less current liabilities. However, the most important current asset is cash. All creditors want payment in the form of cash. Timing of cash receipts and corresponding liability payments is dependent on good cash management.

Working capital management is a function of financial management whereby the business ensures there is adequate cash to meet the day-to-day, weekly, monthly and quarterly needs. To successfully plan the inflows and outflows of cash, the finance director must first understand the cash cycles of the individual accounts for both current assets and corresponding current liabilities.

Each of the current asset accounts and current liability accounts have a different cash cycle time. Some are strict in nature, others more flexible. Understanding these individual account cycles is the first element of three involved in working capital management. ACT ON KNOWLEDGE.

© 2016 – 2022, David J Hoare MSA. All rights reserved.

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