Understanding Working Capital

Working Capital means funds that are used for running the day to day operations and trading.

It can be defined through a simple formula:
Working Capital = Current Assets- Current Liabilities
Current Assets include Cash, short term debtors, trade debtors, inventory and other assets that can be expected to convert into cash within a year;
Current liabilities include trade creditors, other short-term debts, accounts payable, accrued liabilities and other liabilities that are to be paid off in less than one year.

The logic behind this formula is that only the amount which is over and above current liabilities can actually be used in running operations of a business. Rest to the extent of current liabilities is like “pledged” funds. Healthy or positive working capital means that business has a favourable cash conversion and is able to generate funds internally from operations to meet the fund requirement of running the operations. 

Working Capital Cycle

Working Capital cycle

Working Capital cycle

The above figure shows a typical working capital cycle. Cash is used to purchase raw materials . The raw materials are then turned into finished goods and sold to customers, usually for a credit period. Ultimately payment is received in cash from the customer and the cycle repeats. Sometimes working Capital can turn negative but before jumping to conclusion about it let us discuss it in length.

What Does Negative Working Capital Mean?

Now the first conclusion about negative working capital would be low efficiency and fact that an entity needs external funding even for day to day operations. But having access of short term liabilities over short-term assets is not always unfavourable. A sudden surge in creditors or dip in debtors can be result of one-off bulk payments and adjustments that make working capital negative but for a short period of time.  A negative working capital which sustains over extended period is definitely a cause of concern. It could be because the finished product is being sold at very low margins or loss. This strategy is sometimes followed by companies who are looking at either increasing their market share or introducing new products. Another instance is sizeble bad debts where debtors have gone bankrupt or refused to pay. In such a situation the debtors will have a write-off which would result in a dip in current assets. Loss in inventory by accident can also lead to negative working capital. But for example- financing a fixed asset by cashwill make a hit at current assets position but it is a sign of efficiency where you are able to make investment in fixed assets by using internally generated funds! So this is an instance of a favourable negative working capital.

Working capital is a critical factor to consider in assessing the financial health of any business vis. a vis. the efficient use of its resources. Here, we will discuss various components and pillars of this measure.

Cash Conversion Cycle (CCC)

Cash Conversion cycle is the time taken by a trading or manufacturing concern to realise cash from its inventory and account receivables after meeting its outflows owing to short term payables including trade creditors. It is expressed in terms of number of days and can be defined as follows in form of a formula:-

CCC= Days’ Inventory Outstanding (DIO) + Days’ Sale Outstanding (DSO) – Days’ Purchase Outstanding (DPO)

Cash Conversion Cycle

Cash Conversion Cycle

Let us discuss components of Cash Conversion Cycle - DIO, DSO and DPO in detail now.

Days’ Sale Outstanding (DSO)

DSO is the measure to assess the number of days a concern gives credit to its customers. Let us explain it with a formula:
DSO= Average receivables/ daily sale
Average receivables: Opening balance + Closing Balance/2
Daily sales: Total annual sale/365

DSO can be calculated for every month as well. In fact when there is a revamp of credit terms then DSO should be computed for every month to understand the implication and drop or hike in DSO, as the case may be.

Days’ Purchase Outstanding (DPO)

DPO gives average credit term (days of credit) enjoyed by a concern from its trade creditors. In term of formula, it can be stated as follows:
DPO= Average payables/ Daily purchases
Average payables= Opening balance+ Closing Balance/2
Daily purchases= Total purchases/365
Just like DSO, DPO can also be computed monthly or any period of time as required.

Importance and usage of DSO and DPO

Now that we have discussed the meaning of DSO and DPO, let us understand their implication on a business and cash conversion cycle. Ideally, every trading concern must try to have a bigger DPO and smaller DSO, which essentially implies that they recover cash from debtors in shorter duration and pay off their creditors later.
For e.g. ABC Company has a DSO of 30 days and DPO of 40. This gives an advantage of 10 extra days to ABC Company to meet its payables and it enjoys healthy liquidity to meet its other production and day to day expenses as well.
DSO comparisons also help in effective credit control. If without any re-negotiations, a company observes that its DSO has risen then it means that the collection process is not working well. This situation can be rectified in many ways including putting processes like advance reminders and water tight system of invoicing in place for the starters. If a company has indeed renegotiated terms with both debtors and creditors, then the month on month DSO and DPO comparisons would show the result in line with such re-negotiations.

Days’ Inventory Outstanding (DIO)

The third pillar of CCC deals with inventory. DIO is the average days a trading concern takes to convert its inventory into sale and is stated as follows:
DIO= Average Inventory/ Day’s Cost of goods sold
Average inventory= Opening Balance + Closing Balance/2
Day’s cost of goods Sold (COGS)= Cost of goods sold/365
If the accounting period for which DIO is to be computed is shorter, then day’s COGS will be computed for such other period and 365 days will get replaced accordingly.

Understanding with an example

A trading concern XYZ corp. has provided following details from its Balance-sheet and Profit & Loss account:-


Cash Conversion Cycle (CCC) = DIO + DSO – DPO (33 + 44 -61)= 16 days

The above computation shows that the average days of credit granted by XYZ Corp is almost half at 33 days as compared to the credit days lent by it, which is 61 days.
The average days it takes XYZ Corp to sell its stock is 44 days and the number of days in which it converts its inventory and debtors into cash is just 16 days. These figures picture a very liquid position of XYZ Corp where it is able to meet its able to generate working capital very efficiently.                    

Liquidity or Working Capital Ratios

Cash Conversion cycle is just one part of assessing the working capital position. Other is the computation of Current Ratio, Acid-test Ratio and Cash Ratio. We are discussing these ratios briefly here. For details kindly read your tryst with Liquidity ratios.

Current Ratio

Current Ratio is the basic and the most used amongst the list of liquidity ratios. It is also known as working capital ratio and is stated as below:
Current Ratio= Current Assets/ Current Liabilities
The resultant figure represents the number of times current assets cover current liabilities. Higher the ratio better it is. However, this ratio can be higher even if cash is trapped in receivables and inventories.

Acid Test Ratio

Acid test ratio is also known as quick ratio and it considers only “highly” liquid assets in consideration.
Acid Test ratio = (Current Assets- Stock- prepaid expenses)/ Current Liabilities

Acid test ratio doesn't include inventories but does include receivables and so thought a refinement of current ratio may still mislead at times

Cash Ratio

This one is a further refinement of Acid Test ratio and considers only Cash and cash equivalents for the purpose of measuring liquidity.
Cash Ratio = Cash + Cash equivalents / Current liabilities

The above ratios and Cash Conversion Cycle determine the working capital position of a company. However, we always maintain that one aspect of the entire financial position cannot be considered as representative of the total financial health of a company. So here are a few cautionary words for cases when you just have working capital figures to contend with.

Factors to consider when assessing working capital position of a Company

1.    Healthy and unhealthy working capital position can be generalized only according to the industry and sector an entity is operating in. Some entities by nature have higher liquidity and some low;

2.    Higher liquidity is not always favourable as it may indicate under-utilisation of resources and money. You will need to further dig in to find if this is the case;

3.    Consider recent sale, purchase, construction of an asset, pre-closure of loan or liquidation of a big liability owing to strategic decisions that affect liquidity tremendously;

4.    Change in trade terms, seasonal nature of goods sold also has a strong bearing on liquidity position.

Working capital management is extremely important for companies. It is the main determinant in the liquidity position of a company. Profitable companies can go bankrupt due to a paucity of liquidity.