Working Capital

Working Capital Formula

A key part of financial modeling involves forecasting the balance sheet.

Working capital refers to a specific subset of balance sheet items. The simplest definition of working capital is shown below:

• What makes an asset current is that it can be converted into cash within a year.
• What makes a liability current is that it is due within a year.

Working Capital: Balance Sheet Example

As a working capital example, here’s the balance sheet of Noodles & Company, a fast-casual restaurant chain. As of October 3, 2017, the company had $21.8 million in current assets and $38.4 million in current liabilities, for a negative working capital balance of -$16.6 million:

Current Ratio and Quick Ratio

A financial ratio that measures working capital is the current ratio, which is defined as current assets divided by current liabilities and is designed to provide a measure of a company’s liquidity:

As we’ll see shortly, this ratio is of limited use without context, but a general view is that a current ratio of > 1 implies a company is more liquid because it has liquid assets that can presumably be converted into cash and will more than cover the upcoming short-term liabilities.

Another closely related ratio is the quick ratio (or acid test) which isolates only the most liquid assets (cash and receivables) to gauge liquidity. The benefit of ignoring inventory and other non-current assets is that liquidating inventory may not be simple or desirable, so the quick ratio ignores those as a source of short-term liquidity:

Working Capital Presentation on Cash Flow Statement (CFS)

The balance sheet organizes assets and liabilities in order of liquidity (i.e. current vs long-term), making it very easy to identify and calculate working capital (current assets less current liabilities).

Meanwhile, the cash flow statement organizes cash flows based on whether items are operating, investing, or financing activities, as you can see from Noodles & Co.’s cash flow statement below:

Reconciling Working Capital on the Balance Sheet with CFS

The balance sheet organizes items based on liquidity, but the cash flow statement organizes items based on their nature (operating vs. investing vs. financing).

As it so happens, most current assets and liabilities are related to operating activities^[1] (inventory, accounts receivable, accounts payable, accrued expenses, etc.) and are thus primarily clustered in the operating activities section of the cash flow statement under a section called “changes in operating assets and liabilities.”

Because most of the working capital items are clustered in operating activities, finance professionals generally refer to the “changes in operating assets and liabilities” section of the cash flow statement as the “changes in working capital” section.

However, this can be confusing since not all current assets and liabilities are tied to operations. For example, items such as marketable securities and short-term debt are not tied to operations and are included in investing and financing activities instead (although in the above example, Noodles & Co happened to not have any marketable securities or short-term debt).

Operating Items vs. Working Capital on the Cash Flow Statement

Adding to the confusion is that the “changes in operating activities and liabilities” (often called the “changes in working capital”) section of the cash flow statement commingles both current and long-term operating assets and liabilities. That’s because the purpose of the section is to identify the cash impact of all assets and liabilities tied to operations, not just current assets and liabilities.

For example, Noodles & Co classifies deferred rent as a long-term liability on the balance sheet and as an operating liability on the cash flow statement^[2]. It is thus not included in the calculation of working capital, but it is included in the “changes in operating activities and liabilities” section (which we now know people often also refer to, confusingly, as “changes to working capital”).

Working Capital on Financial Statements

Below we summarize the key takeaways we’ve described from the presentation of working capital on the financial statements:

• While the textbook definition of working capital is current assets less current liabilities, finance professionals also refer to the subset of working capital tied to operating activities as simply working capital. Welcome to the magical world of finance jargon.
• The balance sheet working capital items include both operating and nonoperating assets and liabilities whereas the “changes in working capital” section of the cash flow statement only includes operating assets and liabilities and
• The cash flow statement’s informally named “changes in working capital” section will include some noncurrent assets and liabilities (and thus excluded for the textbook definition of working capital) as long as they are associated with operations.

How to Interpret Working Capital

Now that we’ve addressed how working capital is presented, what does working capital tell us?

Let’s continue with our Noodles & Co example.

• What does the company’s negative $16.6 million working capital balance tell us?

For starters, it tells us that there are $16.6 million more liabilities coming due over the next year than assets that can be converted within the year. This might seem like a troubling metric.

For example, if all of Noodles & Co’s accrued expenses and payables are due next month, while all the receivables are expected 6 months from now, there would be a liquidity problem at Noodles. They’d need to borrow, sell equipment or even liquidate inventory.

But the same negative working capital balance could be telling a completely different tale, namely of healthy and efficient working capital management, where accounts payables, accounts receivable and inventory are carefully managed to ensure that inventory is quickly sold and cash is quickly collected, allowing Noodles & Co to pay invoices as they come due and purchase more inventory without tying up cash and without skipping a beat.

Further, Noodles & Co might have an untapped credit facility (revolving credit line) with sufficient borrowing capacity to address an unexpected lag in collection.

In fact, here’s how Noodles & Co explains their negative working capital in the same 10Q:

“Our working capital position benefits from the fact that we generally collect cash from sales to customers the same day, or in the case of credit or debit card transactions, within several days of the related sale, and we typically have up to 30 days to pay our vendors. We believe that expected cash flow from operations, the proceeds received from the private placement transactions and existing borrowing capacity under our credit facility are adequate to fund debt service requirements, operating lease obligations, capital expenditures, the Restaurant Closing Liabilities, the Data Breach Liabilities and working capital obligations for the remainder of fiscal year 2017.”

In short, the amount of working capital on its own doesn’t tell us much without context. Noodle’s negative working capital balance could be good, bad or something in between.

Working Capital Metrics: Formula Chart

Cash, accounts receivable, inventories and accounts payable are often discussed together because they represent the moving parts involved in a company’s operating cycle (a fancy term that describes the time it takes, from start to finish, of buying or producing inventory, selling it, and collecting cash for it).

For example, if it takes an appliance retailer 35 days on average to sell inventory and another 28 days on average to collect the cash post-sale, the operating cycle is 63 days.

In other words, there are 63 days between when cash was invested in the process and when cash was returned to the company. Conceptually, the operating cycle is the number of days that it takes between when a company initially puts up cash to get (or make) stuff and getting the cash back out after you sold the stuff.

Since companies often purchase inventory on credit, a related concept is net operating cycle (or cash conversion cycle), which factors in credit purchases. In our example, if the retailer purchased the inventory on credit with 30-day terms, it had to put up the cash 33 days before it was collected. Here, the cash conversion cycle is 35 days + 28 days – 30 days = 33 days. Pretty straightforward.

Below is a summary of the formulas required to calculate the operating cycle described above:

Working Capital Management: Operating Efficiency

For many firms, the analysis and management of the operating cycle is the key to healthy operations. For example, imagine the appliance retailer ordered too much inventory – its cash will be tied up and unavailable for spending on other things (such as fixed assets and salaries).

Moreover, it will need larger warehouses, will have to pay for unnecessary storage, and will have no space to house other inventory.

Imagine that in addition to buying too much inventory, the retailer is lenient with payment terms to its own customers (perhaps to stand out from the competition). This extends the amount of time cash is tied up and adds a layer of uncertainty and risk around collection.

Now imagine our appliance retailer mitigates these issues by paying for the inventory on credit (often necessary as the retailer only gets cash once it sells the inventory).

Cash is no longer tied up, but effective working capital management is even more important since the retailer may be forced to discount more aggressively (lowering margins or even taking a loss) to move inventory in order to meet vendor payments and escape facing penalties.

Taken together, this process represents the operating cycle (also called the cash conversion cycle). Companies with significant working capital considerations must carefully and actively manage working capital to avoid inefficiencies and possible liquidity problems. In our example, a perfect storm could look like this:

1. Retailer bought a lot of inventory on credit with short repayment terms
2. Economy is slow, customers aren’t paying as fast as was expected
3. Demand for the retailer’s product offerings change and some inventory flies off the shelves while other inventory isn’t selling

In this perfect storm, the retailer doesn’t have the funds to replenish the inventory that’s flying off the shelves because it hasn’t collected enough cash from customers. The suppliers, who haven’t yet been paid, are unwilling to provide additional credit, or demand even less favorable terms.

In this case, the retailer may draw on their revolver, tap other debt, or even be forced to liquidate assets. The risk is that when working capital is sufficiently mismanaged, seeking last-minute sources of liquidity may be costly, deleterious to the business, or in the worst-case scenario, undoable.