What is working capital? Let’s first go through an intuitive example of what high working capital needs and low working capital needs are. Then we cover a definition of working capital, discuss the relationship between #workingcapital and cash, and calculate the working capital balance for two well-known multinational companies. Let’s dive straight in!
Let’s imagine you operate a “buy-stock-sell” business in children’s toys. You buy from your supplier, hold the toys in stock, then sell to customers. Sometimes the product moves through your business at a nice steady pace, sometimes the process has a bit more variability and the pace is a little slower.
What would you prefer as a business owner, assuming the pricing and profit margins are the same between the two scenarios. Would you vote for option A, where you pay your supplier cash on delivery, hold high inventory levels, and grant customers 45 days credit before they need to pay you. Or would you vote for option B, where you have 45 days credit from your supplier, work with “Just In Time” inventory levels, and have your customers pay cash on delivery.
With option A, there is a high working capital, that somehow needs to be financed by debt or equity. With option B, there is a low working capital, reducing the need for financing. With option A, cash flow and return on assets will be lower. With option B, cash flow and return on assets will be higher.
The definition of working capital that we use in this video is: the total amount of capital invested into your company’s operating cycle (day-to-day operations). I believe this is the most useful way of looking at working capital.
What is the relationship between working capital and cash? Let’s say that your children’s toys company decides on three actions: paying suppliers quicker than before, holding more inventory, and granting customers extended terms. This drives working capital up, and cash down, possibly triggering the need to go out for more financing. If however you stretch supplier terms (pay them later), achieve higher inventory turns, and improve the collections of payments from customers, your working capital would decrease, and as a result your cash would increase, possibly increasing the opportunity to pay down loans, or pay dividends.
Philip de Vroe (The Finance Storyteller) aims to make strategy, #finance and leadership enjoyable and easier to understand. Learn the business and accounting vocabulary to join the conversation with your CEO at your company. Understand how financial statements work in order to make better investing decisions. Philip delivers #financetraining in various formats: YouTube videos, classroom sessions, webinars, and business simulations. Connect with me through Linked In!