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Working Capital Management Analysis

Working capital is a financial metric that represents the operational liquidity of a business, organization, or other entity.

Learning Objective

  • Identify working capital and discuss how a company would use it


Key Points

    • Net working capital is calculated as current assets minus current liabilities. Positive working capital is required to ensure that a firm is able to continue its operations and has sufficient funds to satisfy both maturing short-term debt and upcoming operational expenses.
    • Cash flows can be evaluated using the cash conversion cycle -- the net number of days from the outlay of cash for raw material to receiving payment from the customer.
    • Profitability can be evaluated by looking at return on capital (ROC). This metric is determined by dividing relevant income for the 12 months by the cost of capital used. When ROC exceeds the cost of capital, firm value is enhanced and profits are expected in the short term.

Terms

  • discounted cash flows

    A method of valuing a project, company, or asset using the concepts of the time value of money. All future cash flows are estimated and discounted to give their present values (PVs) — the sum of all future cash flows, both incoming and outgoing, is the net present value (NPV), which is taken as the value or price of the cash flows in question.

  • deficiency

    Inadequacy or incompleteness.


Full Text

Definition of Working Capital

Working capital (abbreviated WC) is a financial metric that represents the operational liquidity of a business, organization, or other entity. Along with fixed assets, such as property, plant, and equipment, working capital is considered a part of operating capital. Positive working capital is required to ensure that a firm is able to continue its operations and has sufficient funds to satisfy both maturing short-term debt and upcoming operational expenses. A company can be endowed with assets and profitability but short on liquidity if its assets cannot be converted into cash .

If money grew on trees, companies would never have a working capital shortage.

Sufficient working capital ensures a company is able to meet its short term obligations.

Uses of Working Capital

Net working capital is calculated as current assets minus current liabilities. It is a derivation of working capital commonly used in valuation techniques such as discounted cash flows (DCFs). If current assets are less than current liabilities, an entity has a working capital deficiency, also called a working capital deficit. The ability to meet the current portion of debt (payable within 12 months) is critical because it represents a short-term claim to current assets and is often secured by long term assets. Common types of short-term debt are bank loans and lines of credit.

Managing Working Capital

Decisions relating to working capital and short term financing are referred to as working capital management. These involve managing the relationship between a firm's short-term assets and its short-term liabilities. The goal of working capital management is to ensure that the firm is able to continue its operations and that it has sufficient cash flow to satisfy both maturing short-term debt and upcoming operational expenses. Working capital management entails short-term decisions, usually relating to the next one-year period and are based in part on cash flows and/or profitability.

Evaluating Working Capital Management

Cash flows can be evaluated using the cash conversion cycle -- the net number of days from the outlay of cash for raw material to receiving payment from the customer. Because this number effectively corresponds to the time that the firm's cash is tied up in operations and unavailable for other activities, management generally aims for a low net count.

Profitability can be evaluated by looking at return on capital (ROC). This metric is determined by dividing relevant income for the 12 months by the cost of capital used. When ROC exceeds the cost of capital, firm value is enhanced and profits are expected in the short term.

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