Although the phrase "working capital" is common in business and finance circles, it is often very misunderstood. Here's an example: if I was to ask you if you would rather own a business with a lot of instead of a little, what would be your answer? Most people would prefer the business with a lot. But the answer is not that simple, and, in many cases, less actually indicates better management and cash flow generation. I will take a few paragraphs to discuss the two main reasons why this is misunderstood and then discuss the best measurement tool I know to monitor it.
IT DOES NOT EQUAL CASH
It is often misunderstood for cash. It is actually the difference between all of your current assets (cash, accounts receivable, etc.) and your current liabilities (accounts payable, accrued expenses, etc.). Notice that cash is actually only a part of this equation, and it is usually a smaller part at that. So, what in the world is working capital?
The easiest way to explain it is in terms of the number of days difference between when you pay for things and when you get paid. Here is a simplified example:
Cash goes out to pay for parts and labor to build a widget. After 10 days the widget is ready to be sold. It takes another 20 days to sell the widget to a customer on credit (net 30 terms). The customer pays early - in 25 days. The total cycle is 55 days. Hence, the business needs to have enough "working capital" to fund this transaction until it gets paid.
IT IS A CYCLE OF CASH FLOW
Based on the example above, a business will need a certain amount of funds to handle this 55-day cycle. But what if the company can improve its manufacturing process and get paid a little earlier, reducing its working capital days to 42? This means the company would need less working to fund its operations. Since most people confuse it for for cash, we think a bigger number is better. But companies that run an efficient cycle require less funds, the sign of a well-run and efficient business.
HOW SHOULD IT BE MEASURED?
There are lots of measurements that comprise working capital - days sales outstanding, inventory days, payables days, and more. Trying to look at all of these and make sense of the company's progress is tough. So, we use a ratio that measures working capital days - one number to illuminate the entire cycle. This nominalizes the number and makes it easy to initially spot issues and challenges.
Very simply, the formula is:
(Average working capital for a period/sales for the period)*(# of days in the period)
If I told you that you have a working capital balance of $500,000, it would be hard to understand if that was good or bad until you compare it to other periods of time in your business. If you are growing or shrinking, it becomes more difficult to know if your cycle is accelerating or decelerating, or if you are squeezing more or less cash out of your operations.
HOW SHOULD WORKING CAPITAL BE FINANCED?
Financing it is actually quite simple once we understand this days ratio. At a company's maximum efficiency, there is a minimum number of days in its cycle - maybe it is 15 days, or maybe it is 60 days. Regardless of the number, this part of the cycle should usually be funded with permanent debt or equity.
I have yet to see a business that can function at their most efficient cycle for very long. This is caused by spikes and drops in sales as well as new opportunities and new challenges that often arise daily. The days in the cycle above this most efficient level is usually best financed with lines of credit or other revolving debt facilities. Sometimes it is financed with retained earnings or equity, but that may not be the most effective use of the firm's capital.
CONCLUSION
This is a measure of the firm's ability to streamline its operations to generating cash as quickly as possible. When understood in this light, less is actually more.
Our CFO services help companies get their arms around this concept and maximize their cash flow. Business is, ultimately, about cash generation. The working capital cycle of a business can either gobble up more than its fair share of cash or it can be managed as an efficient cash flow system. If managed, it can become one of the company's most significant competitive advantages.
Ken Kaufman, Founder & CEO
CFOwise
CFO Services
CFOwise is the premier CFO firm for start-up, emerging, and medium-sized companies
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