The Working Capital category examines your reserves. You do not want too much or too little working capital. There are three criteria:
Working Capital = Current Assets minus Current Liabilities
Current Ratio = Current Assets / Current Liabilities = (Cash + A/R + Inventory) / (A/P + Current Debt)
Days of Working Capital = Working Capital / (Sales/365)
For example, in the sample below, you would earn 50 points for a Current Ratio of 3.2, another 50 points for a Working Capital Days of 65, and you would keep the points because you avoided an Emergency Loan.
ASSETS ($000) LIABILITIES & OWNER'S EQUITY Current Assets Liabilities Cash $1,260 Accts Payable $6,291 Accts Receivable $7,522 Current Debt $3,500 Inventories $22,388 Current Liabilities $9,791 Current Assets $31,170 Long Term Debt $39,000 Total Liabilities $48,791 Fixed Assets Plant & Equip. $113,800 Owner's Equity Accum. Deprec. ($45,900) Common Stock $18,276 Total Fixed Assets $67,900 Retained Earn. $32,003 mall;">Total Equity $50,279 TOTAL ASSETS $99,070 TOTAL LIAB. & O.E. $99,070 Working Capital $21,378 Current Ratio 3.2 Sales ($000) $120,000 Days of Working Capital 65.0
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.
Inventory and Cash must be considered together. You can think of inventory as crystallized Cash. If you sell the Inventory, it is converted back to Cash. If demand is below expectations, Cash is converted to Inventory. Since you cannot predict what competitors will do, you cannot predict demand perfectly. (This will be explored further in the Forecasting section of this report.) Therefore, your Cash plus Inventory position is a hedge against two risks — the risk of stocking out, and the risk of building too much inventory.
The $31 million in Current Assets came out of somebody's pocket. Naturally, owners and managers want to know how much was funded from their equity (common stock and retained earnings), and how much from the two relevant debt holders, bankers (current debt) and vendors (accounts payable). Working Capital is the Equity portion that came from owners and managers, and Current Liabilities is the Debt portion.
Equity holders and debt holders have competing interests.
Equity holders would prefer to minimize Working Capital. There are two methods at their disposal — fund Current Assets with debt, or reduce Current Assets.
Let's explore funding Current Assets with debt. Debt holders worry that if they fund too much of the Current Assets, the company might default during difficult times. Debt holders monitor the situation with the Current Ratio.
Current Ratio = Current Assets / Current Liabilities
Where Working Capital looks at the issue from the Equity holder's perspective (how much of my Equity is in use), the Current Ratio is looking at the issue from the Debt holder's perspective. If the Current Ratio is 2.0, for every $2 of Current Assets, you have $1 of Current Liabilities and therefore $1 of Equity invested. If it is 3.0, then for every $3 of Current Assets there is only $1 from Debt holders. The bigger the number, the less the risk faced by Debt holders.
A Current Ratio of 1.0 means Current Assets are entirely funded with Current Liabilities. Bankers and vendors hate to see your Current Ratio at 1.0 because if anything goes wrong, you cannot pay your bills, and this puts them in the awkward position of either giving you more money or letting you go bankrupt. As the Current Ratio rises towards 2.0 they become less worried.
Now let's examine reducing Current Assets. Consider these cases:
Sales $100,000 CASE 1 ASSETS ($000) LIABILITIES & OWNER'S EQUITY Current Assets Liabilities Cash $6,500 Accts Payable $6,000 Accts Receivable $7,000 Current Debt $4,000 Inventories $6,500 small;">Current Liabilities $10,000 Current Assets $20,000 Current Ratio 2.0 Days of Working Capital 36.5 CASE 2 ASSETS ($000) LIABILITIES & OWNER'S EQUITY Current Assets Liabilities Cash $2,500 Accts Payable $6,000 Accts Receivable $7,000 Current Debt $0 Inventories $2,500 Current Liabilities $6,000 Current Assets $12,000 Current Ratio 2.0 Days of Working Capital 21.9
Case 1 and 2 both have Current Ratios of 2.0, but Case 2 is much more worrisome. If demand increases, you stock out after selling only $2.5 million of inventory. If demand falls, you run out of cash after building only $2.5 million of additional inventory. You have little room for error.
Days of Working Capital
To a degree, this issue is exposed in the Working Capital magnitude. Case 1 features Working Capital of $10 million; Case 2 only $6 million. Yet this ignores the question of how much Working Capital you really need. That is driven by sales volume over time. For a small company, $6 million might be adequate and $10 million too much. For a large company, $10 million might be too little.
Days of Working Capital = Working Capital / (Sales/365)
This issue is addressed in "Days of Working Capital", defined as Working Capital / (Sales/365), or more simply, the number of days we could operate before our Working Capital would be consumed. You get 50 points if your Days of Working Capital falls between 30 days and 90 days.
In the example above, where sales are $100 million per year, Case 1 features 36.5 Days of Working Capital. That is a bit on the thin side, but within acceptable limits. Case 2 is too thin at 21.9 Days of Working Capital.
CASE 3 ASSETS ($000) LIABILITIES & OWNER'S EQUITY Current Assets Liabilities Cash $0 Accts Payable $6,000 Accts Receivable $7,000 Current Debt $4,500 Inventories $14,000 Current Liabilities $10,500 Current Assets $21,000 Current Ratio 2.0 Days of Working Capital 38.3
Case 3 is a variation on Case 1. It illustrates what can happen when you start with thin reserves. There are 38.3 Days of Working Capital, and the Current Ratio is 2.0. Things look okay, but notice that you have no Cash. Our sales forecast was too optimistic. Inventory accumulated beyond our worst case, consuming all of our Cash. We were forced to take an Emergency Loan from Big Al. While one could argue that the problem here was forecasting, we were forecasting in an environment where we were tight for Working Capital. A small error resulted in disaster.
To summarize, your Working Capital position is the consequence of a set of policy decisions.
The equity portion is your Working Capital. These policy decisions can be evaluated with the Current Ratio and Days of Working Capital.