Working Capital Series: Closing the Financing Gap (Pt. 1)

This is a two part series. In the first part you learn how to get out of a short-term financing gap by increasing working capital. In the second part you learn how to increase profitability by optimizing working capital. Put together, this two part series shows you how to maintain a healthy working capital and improve profitability with the use of working capital funds and the adoption of new working capital processes.

Part 1: How To Increase Working Capital

Much of financial wisdom revolves around the bird in the hand theory. The idea is that a bird in the hand is worth two in the bush. In other words, cash has more value in your hand today than it does tomorrow because you can invest it. 

Operating a business is more than sales growth. Good business, especially for manufacturers, distributors, retailers and contractors is about managing cash flow. This is easy for a ‘cash only’ company, but when credit sales are added it tends to get a little complicated because the sale is made but the bird is not in the hand. According to a recent working capital practices study of the manufacturing and distribution industry16.1 percent of accounts receivable are still ‘in the bush’ 180 days after the sale is made. Not only is there an opportunity cost associated with extended credit sales, but you incur interest for financing the loan to your customer. If properly managed, however, working capital can be a source of income. This is especially the case for those businesses that use invoicing as a way to collect sales and pay suppliers.

What Is Working Capital?

Before discussing how to increase working capital, let’s define it. Working capital is the difference between current assets and current liabilities. 

Current Assets - Current Liabilities = Working Capital

You will find this definition repeated everywhere, but what exactly does it mean? In a nutshell, working capital is code for ‘short-term cash flow’ or liquidity. 

Current assets that can be converted into cash within one year. They include: cash, accounts receivable, short-term investments (cash equivalents) and inventory

Current liabilities are liabilities that will be paid within one year. They include: accounts payable, accrued expenses, taxes, customer deposits and the portion of long-term debt that’s due within one year

For example, if a company sells $41,000 of product for $50,000 on credit, working capital will increase by $9,000. Working capital increases because accounts receivable goes up by $50,000 and inventory decreases by $41,000. There’s no change in current liabilities. Also keep in mind that while the purchase of inventory with cash has no impact on working capital, the purchase of a building reduces working capital because the building is a long-term asset.

If the difference between current assets and current liabilities is greater than zero you have positive working capital. If the difference is less than zero you have negative working capital. 

Trying to interpret working capital can be a bit tricky and almost always depends on the business and its industry. There are some generalizations analysts can make, however. 

  • positive working capital means you do have enough assets to cover liabilities in the short-term. 
  • A negative working capital means you do not have enough assets to cover your liabilities in the short-term.
  • A company with positive working capital is generally healthier than a company with negative working capital, but a high working capital isn’t always better. 
  • A company with negative working capital can be healthy, but only if it has access to large amounts of cash like a line of credit
  • A company with high working capital can fund its own expansion without taking on new debt. 
  • A company with high working capital may also be indicative of a company that’s having a hard time converting inventory and accounts receivable into cash. This is a situation where the company can pay off its creditors, but only if it liquidates accounts receivable and inventory.

Closing The Working Capital Gap

Working capital shortages can be created from a number of different business events. A decline in sales, an increase in past due receivables, a temporary increase in labor and any number of inventory turnover problems can lead to a short-term financing gap. So what can you do when there’s a working capital shortage? From an operational perspective it means you have a financing gap and need to increase cash immediately. That cash can be used to pay off short-term debts, which brings your working capital into positive territory. The gap can be filled through the sale of long-term assets, the sale of equity or the use of a short-term loan like a revolving line of credit. Best case scenario, you can use accounts receivable as the collateral for a revolving line of credit.  

Part Two: Moving From Crisis To Management

Part two of this series steps out of crisis mode and into working capital management. It is the process of optimizing working capital that makes it profitable. By adopting best practices from competitors, CFOs can optimize working capital and improve profitability. 

Posted in Finance, Management