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We all know what working capital is (or at least we think we do). It’s current assets minus current liabilities. Right? Right. But if that is all you know, it isn’t that insightful.
Knowing the ins and outs of working capital can mean the difference between having to invest millions of dollars in your business or paying a million dollar dividend to the owners.
To get a better understanding of what working capital is and what it means for your business’s cash, let’s contrast three hypothetical companies as an example - Company A, Company B, and Company C.
Assume each company offers identical goods and services. Let’s also assume that each company generates $10 million in sales, $5 million in gross profit, and $3 million in net income per year.
On the surface, each company is identical. However, a closer look at each company’s balance sheet exposes important differences in working capital management practices.
Let’s say that Company A has $0 accounts receivable, inventory, and accounts payable, Company B has $500K of accounts receivable, inventory, and accounts payable, and Company C has $1 million of accounts receivable, inventory, and accounts payable.
One of these companies needs to immediately invest more money into their business, one is doing just fine, and the other should likely pay its owners a $500K dividend.
Confused? Don’t be.
I like to think of a business and its working capital as akin to a car and its gas. The car in this analogy represents the business itself - its people, machines, and equipment. The gas represents working capital - accounts receivable, inventory, and accounts payable.
A car with no gas in the tank requires you to immediately spend money to fill up the gas tank. This is Company A. It does not have enough working capital.
A car with a full-tank of gas is ready to drive. This is Company B. It has the right amount of working capital.
A car with a full-tank of gas that is towing a 5,000 gallon tank of gas behind it “just in case” is not being operated efficiently; the nearest gas station is usually just a mile or two away. This is Company C. It has too much working capital.
The point is that how a company manages its working capital directly impacts how much cash is required to run the business efficiently. If you are a current or prospective business owner, this should be important to you.
For most businesses, the main drivers of working capital are accounts receivable, inventory, and accounts payable.
Let’s return to our three company example to see this in practice.
Company A
$0 of accounts receivable: If we assume this company offers its customers 30 day payment terms, having $0 in accounts receivable is not a good thing. It means that this company is not expecting to collect any cash over the next 30 days and thus must use cash on hand (or invest additional cash) to fund its business needs for the next month.
$0 of inventory: The company has no inventory to sell to its customers. This indicates that the company would need cash to buy or make product before it can generate sales.
$0 of accounts payable: This may indicate that the company has used all of its cash to pay its creditors early and/or that its suppliers do not provide it with any payment terms. Neither is ideal. A much better situation is to take advantage of the payment terms offered by your vendors.
The owners of Company A have $0 in working capital. Company A is the car with no gas. It does not have enough working capital and will need to immediately put money into its business to make it operational. This fact not only affects day-to-day operations, but also would negatively impact the company’s sale price if it were to be sold today.
Company B
Company B manages its working capital quite well.
$500K of accounts receivable: Assuming that the company offers its customers 30 day payment terms, this level of accounts receivable indicates that customers are paying in 18 days on average. This is great - customers are actually paying early. It also indicates that the company can expect $500K of cash to be received over the next 30 business days.
$500K of inventory: This inventory level indicates that product is turning over 10 times a year on average; in other words, that it has a 37 days supply of inventory on hand. This can be good or bad depending on the standard KPIs for the industry (a lower level of inventory may in fact signal an efficient “just in time” supply chain). When compared with Company A, we know Company B has enough inventory to immediately generate sales to willing customers.
$500K of accounts payable: The level of accounts payable indicate that invoices are being paid in 37 days on average. This also seems reasonable, as most vendors allow for 15 to 45 day credit terms, and thus Company B seems to be paying its creditors on time, but not so early as to have used all of its cash.
The owners of Company B have $500K in working capital. Company B is like the car with a full gas tank. With some context, it appears to have just the right amount of working capital.
Company C
Company C is similar to Company A; its accounts receivable, inventory, and accounts payable figures indicate some room for improvement in working capital management services.
$1 million of accounts receivable: This figure would indicate that customers are paying for goods in 37 days on average. If we assume that Company C also offers its customers 30 day payment terms, this indicates that customers are paying late and that the company may have a collection issue.
$1 million of inventory: Inventory levels indicate that inventory is turning over at 5 times a year on average, or that the company has 73 days of inventory on hand. Compared to Company B, this suggests that they are holding too much inventory and could have supply chain inefficiencies or a slow down in sales demand.
$1 million of accounts payable: Accounts payable indicate that Company C is paying its vendors in 73 days on average. Assessing this requires more information. On one hand, this could be a sign of having great payment terms with its vendors. However, it is uncommon for vendors to be so generous with their payment terms. This is more likely a red flag and suggests that vendors are not being paid in a timely manner.
The owners of Company C have $1 million in working capital. Company C is the car that it is towing 5,000 gallons of extra gas. It is not collecting receivables on time, is holding too much inventory, and is paying its vendors late. As a result, it has $1 million of working capital. If Company C could improve its collections and inventory management, it has the potential to lower its working capital to levels on par with Company B, in turn freeing up $500K of cash. This cash could then be used to pay a dividend and/or reinvest into growing its business.
A summary of the working capital metrics of each company is presented below.
Summary
All else equal, Company B is the better managed company. But context matters. Each business and each industry is unique; there is no “one-size-fits-all” approach to working capital management.
The takeaway for all businesses, however, is the same. Understanding what the “right” level of working capital is for your business/industry and proactively managing working capital is critically important. Effective working capital management can have a significant impact on your business’s cash position.
Have questions and/or concerns about working capital? Cronkhite Capital can help. The partners at Cronkhite Capital have over 10 years of experience helping small to medium sized businesses across industries manage their cash and improve their working capital. For a free consultation, please reach out directly to Ryan Hammon. Email - rhammon@cronkhitecapital.com Phone - (415) 847-8103.
