Working Capital

Cash is the lifeblood of every business. Without cash a business operation can come to a standstill. Cash is one component of working capital, a term referring to current assets (Gross Working Capital) less payables and accrued expenses.

The term is usually used in finance referring to the dollar value of flexibility management has to address expansion or endure economic hardships. Of course cash is the most flexible of all the current assets. There are many variations of this term and this article will explain the first two. They include:

* Gross Working Capital
* Net Working Capital
* Working Capital Cycle
* Working Capital Management
* Quick Ratio

The remaining three are explained in other articles. For the novice business person the common usage of the term in referencing all current assets is correctly stated as ‘Gross Working Capital’.

Gross Working Capital

Essentially gross working capital is the dollar value of all current assets. This includes:

* Cash
* Investments
* Inventory
* Accounts Receivable
* Prepaid Expenses

Remember working capital refers to the flexibility to take advantage of an opportunity or endure setbacks. Cash provides this at 100% of value. But what about the other current assets? How much flexibility is really there?

Let’s start with investments. Typically an investment takes about three days to turn into cash and usually there is a cost included to ‘Cash Out’. The normal discount (cost) on investments is two to five percent. Flexibility begins to decrease as management addresses other current assets. For example with inventory it depends on the nature of the inventory and timing. Christmas decorations can be liquidated quickly in November and early December; but in February, very unlikely a business can easily turn these decorations into cash.

Receivables are almost similar. If credit is extended for 30 days, what is the likelihood of day 7 collecting on that receivable account? Some businesses use ‘Same as Cash’ programs and grant customers up to six months to pay without an interest charge. This type of an account is still a receivable, but is it flexible?  With prepaid expenses, it is almost impossible to get your cash back. If possible, the usual delay is upwards of six weeks. To say the term ‘Gross Working Capital’ and quantify the entire value of all current assets is a mistake. More sophisticated businessmen will discount the entire value down to as low as the cash value only depending n the nature of the business. Let’s look at an example:

Take a look at the current assets of this company.  How much will you value the Gross Working Capital?

                                   Current Assets
                              September 30, 2015
Current Assets:
  Cash                                                           $92,705
  Accounts Receivable                                 103,202
  Inventory                                                   792,660
  Prepaid                                                       14,109
  Total                                                      $1,002,676

In this case, look at the date. Do you honestly think the company is going to sell a lot of boats during the fall and winter? Highly unlikely and so the inventory shouldn’t even be considered in determining Gross Working Capital. Technically, it should; but don’t kid yourself. The business has tied up money in inventory.

Prepaid expenses are commonly insurance and taxes. Very doubtful the business can use this as cash for flexibility. If you determined that the working capital is approximately $196,000 then you have a superior understanding of Gross Working Capital.

Net Working Capital

Net Working Capital or often referred to as working capital is gross working capital LESS accounts payable and accrued expenses. Since these two current liability accounts are customarily due within 30 days of incurring the liability, cash is needed to fund the corresponding disbursements.

Unlike receivables where credit is often extended for longer periods of time to customers, vendors and suppliers don’t provide the same courtesy. Most suppliers are adamant about 30 days for payment. The ability to discount payables is practically nil. Accrued expenses are different. The most common accrual is employee vacation and sick time. It is unusual for a company to allow all employees to take vacation at the same time (some small businesses will do this for Christmas week, but it is rare). Accrued expenses are not necessity paid out during the next 30 days, so discounting this value is reasonable.

Based on the knowledge learned thus far what is the Net Working Capital for this company?

                            PEARL’S HVAC
                        Partial Balance Sheet
                              April 30, 2015
   Current Assets:
        Cash                                        $81,200
        Accounts Receivable                19,300
        Inventory                                  33,400
        Prepaid                                      4,100
        Total Current Assets                                $138,800
    Current Liabilities:
         Accounts Payable                  $27,600
         Accrued Expenses                   16,200
         Bank Note                                20,000
         Credit Card                              12,000
         Total Current Assets                                  $75,800

To determine the Net Working Capital the owner or accounting first calculates Gross Working Capital. Since this is an HVAC company in the early spring it is unlikely any units in inventory will get sold soon. Inventory is discounted completely. As always, prepaid expenses are discounted completely because of the amount of time required to get paid in cash. However with receivables an historical collection schedule would be beneficial but since winter is over more than likely a good percentage of this $19,300 is either slow pay or uncollectible. So it only leaves cash. In my opinion I would estimate Gross Working Capital at approximately $83,000 (all cash and some receivables).

To calculate Net Working Capital you must subtract payables and accrued expenses. I would imagine that the accrued payroll is the amount owed for the next payday and some vacation. Therefore it is reasonable to use the entire amount of accrued payroll in calculating Net Working Capital. So the formula is:

Gross Working Capital minus Accounts Payable and Accrued Expenses; therefore,
Net Working Capital = $83,000 – $27,600 – $16,200; therefore,
Net Working Capital = $39,200

Before summing up it would be negligent of me to not explain the other two liabilities.

Working capital can be greatly affected by a demand from the bank to payoff the note. Bank loans [link both words to the article ‘Secured and Unsecured Loans’] have various terms including due dates and demand time frames. If this note were due within 30 days, this would greatly affect working capital because the note is similar to an account payable (due within 30 days). If true, then working capital decreases to $19,200. So pay attention to timing issues for other current liabilities.

Credit card debt is so similar to accounts payable with the exception of the revolving feature (minimum payment allowing balance to cycle to the next period). It is good business to pay these off as they are due. In this case, the accountant should deduct this value as if credit cards were just like accounts payable.

Therefore if the bank note is due soon and management elects to pay off the credit card the true Net Working Capital is $7,200 as follows:

Gross Working Capital                   $83,000
    Accounts Payable           $27,600
    Accrued Payroll               16,200
    Bank Note                        20,000
    Credit Card                       12,000
    Sub-Total                                      75,800
Net Working Capital                         $7,200

Key Business Principle




Summary – Working Capital

The term working capital is used in context with the respective subject matter. In almost all cases the real working capital value is significantly less than the technical definition. The term’s correct meaning is all Gross Working Capital (current assets discounted based on business attributes) less accounts payable and accrued expenses. A sophisticated owner will include any liabilities that will come due within the next accounting cycle to determine a more realistic value for working capital. ACT ON KNOWLEDGE.

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