It’s the lifeblood of a company

Many financial professionals consider working capital as the lifeblood of a company. What exactly is working capital, though? In short, working capital is what companies use to cover upcoming debt obligations. The formula for working capital follows: Working Capital = Current Assets – Current Liabilities.

Current assets are assets a company converts to cash in 12 months or less. Most current assets for a company include cash and equivalents, accounts receivable and inventory. Current liabilities represent the liabilities a company must pay in the next 12 months. Examples of current liabilities include principal and interest payments due to creditors/banks and accounts payable due to vendors/suppliers. Working capital measures the company’s ability to convert current assets to cash to satisfy obligations to creditors and/or suppliers.

For example, a company reports on its balance sheet current assets of $10 in cash, $20 in accounts receivable and $50 in inventory. On the liability side, the company reports current liabilities of $20 due to banks and $20 due to suppliers (accounts payable). Current assets total $80, and current liabilities total $40. Therefore, this company’s working capital position is $80 minus $40, which equals $40 in working capital.

Working capital strategy The cost of working capital causes large burdens on companies due to the amount of cash required to sustain a profitable working capital position. The cash burden imposed by working capital is the second most common reason companies experience financial difficulty, with failure to continuously generate a profit as the most common reason companies fail. Overdependence on working capital requires a lot of cash, which can make it difficult to pay suppliers and even employees.

The amount of working capital a company requires depends on the business model of that particular company, the industry it operates in, and how it positions itself with its customers.

For example, companies that rely on selling inventory to generate revenues (e.g., tire stores, grocery stores, etc.) employ aggressive working capital strategies to ensure the company meets obligations as they come due. Companies that do not rely on selling inventory to generate revenues (e.g., tow truck companies, transportation companies, etc.) employ a different working capital strategy as they depend more on their fixed purchases for long-term use {and not likely to convert to cash quickly) to generate sales instead of their current assets.

Accounts receivable impact on working capital Fast-growing companies require more working capital, particularly companies that extend credit to their customers instead of collecting cash payments by creating an asset known as accounts receivable. Accounts receivable work much like a loan, wherein a company sells their goods to a customer on credit. Each month that customer pays the agreed-upon payment back to the company until the customer pays back in full that receivable (i.e., loan).

For example, a car dealer purchases 1,000 tires at $200/tire from a tire manufacturer through that manufacturer’s credit department over a five-year term instead of paying cash up front. This transaction creates a $200,000 account receivable due to the tire manufacturer. As such, that tire manufacturer has extended $200,000 worth of goods to the tire store without receiving cash up front, meaning the manufacturer has $200,000 in cash tied up in this account receivable. The tire manufacturer in this situation requires a lot of cash to sustain its working capital as it must still pay its suppliers/vendors for the materials to make tires while it waits for the car dealer to pay the $200,000 in full over the next five years.

Conclusion While the formula for working capital is straightforward, knowing how to appropriately fund working capital might be the difference between successful operations and insolvency. Which strategy and amount of funding depends on the industry and how a company positions itself with its customers. As the lifeblood of a company, managing working capital must be a top priority for all small business owners.

Ryan Thomas With over a decade in banking, Ryan Thomas, CRC, spent the majority of his career underwriting and analyzing commercial loan requests. He holds his bachelor of science in aerospace studies from Embry Riddle Aeronautical University and his baster of business administration from LSUS. Thomas is a graduate of the Graduate School of Banking at LSU where he was elected as the 2017 class vice president. He recently received his Credit Risk Certification designation. He manages the loan review department for a local bank. Contact him at rthomas@cbofla.com.