Why Worry About Working Capital?

Why should you be keenly concerned with Working Capital? Let's take a closer look at the dynamics.

One needs to make a distinction between "The Company" and "The People That Have a Claim on the Company". The Balance Sheet makes this clear. The Assets are The Company, and they are listed on the left side. The Liabilities and Owner's Equity on the right side represent the people that paid for the Assets and their current stake. If a bulldozer scraped the Assets into a pile, it would consist of cash, invoices, inventory, bricks, and equipment. Next to the pile a row of people would line up to make a claim — a vendor, banker, bondholder, stockholder, and (representing Retained Earnings) a manager. This is why a Balance Sheet always balances. The left is "what is owned", the right is "who owns it".

Take another look at the Assets. They are split into two categories, Fixed and Current. At a deep level, the Fixed Assets create wealth. The Current Assets could be characterized as "a cost of doing business" or worse as "a necessary evil". In a perfect world, you would have $1 of Cash, $1 of Accounts Receivable, and $1 of Inventory. Indeed, these are often goals for just-in-time initiatives. Cash creates insignificant wealth (and in Capstone® you do not even earn interest). Accounts Receivable is a loan given to customers. Unsold Inventory consumes resources and costs money to carry.

In the example above, $31 million is locked in Current Assets. If you could put that money to work at, say, 10%, you would earn $3.1 million.

Why give that up? The argument for Accounts Receivable terms (say 30 days) is that it increases demand, and at some point the profits from the increased demand are greater than the cost of the money we are lending to customers. However, if every competitor offers 30 days, you get no additional gain in demand, yet bear the cost of the loans you give customers. You only see increased demand if there is a spread between your policy and competitors. Typically, you cannot reduce your policy because you would see a decrease in demand.