At its bare bones, “capital” is wealth. But as the definition is fleshed out, it becomes clear that not all kinds of capital are alike. Every employee needs to understand the basics of working capital to ensure they are equipped to make the best decisions for the company.
Working Capital Definition
Working capital (also known as net working capital) is the amount of funds needed to run a business day to day. It includes cash required to maintain inventories and pay expenses.
The main difference between working capital and other types of capital is that working capital, by definition, circulates through the business, unavailable for other uses. It’s not machinery, land, and buildings, which are fixed assets. Rather, it’s the rhythmic needs of the business: inventory building up then being sold, waiting on money to come back in from sales, paying bills, renewing inventories, and starting all over again.
How Do You Find Working Capital?
Working capital is equal to current assets minus current liabilities. Working capital can be found by adding cash, accounts receivable, and inventory, then subtracting the accounts payable (unpaid bills) and other short-term financing obtained by the business’s current assets.
Working Capital Equations:
Working Capital = Current Assets – Current Liabilities
Working Capital = (Cash + Accounts Receivable + Inventory) – (Accounts Payable + Short Term Financing)
The game board for our business simulations visually shows a company’s balance sheet and income statement, making it easy for participants to calculate key metrics like working capital.
Being Informed by Working Capital
Working capital is an immediate concern from an operational standpoint. It’s also very much related to cash flow, which we have previously explored. For example, when salespeople make a significant sale but won’t be paid for two months, the company’s working capital needs to increase dramatically. A lot of money will sit in receivables for months without coming into usable cash.
Suppose a company runs four power plants, and each plant has to have an inventory of wiring and other tools and equipment to be used if anything goes wrong. The company doesn’t want to cut back on those necessary items, but it could keep those parts and tools in a central location available to each plant. This would require less working capital since the smaller inventory frees up cash that can be used for other things.
Companies want their working capital to be as lean as possible. They want customers to pay faster, reducing “days sales outstanding.” They also want to work with lower inventory levels and wait longer to pay their bills, if possible.
Working Capital Examples
Non-Cash Working Capital Example
The CFO of one of our clients is aiming to free up non-cash working capital. Non-cash working capital is the same as working capital without cash calculated in the current assets. The CFO wants more money to invest and leverage for other projects. He’s driving that thinking down to everyone in the company so they can “up their game.”
He’s getting everyone in the company to look at the balance sheet to understand where money is tied up. He knows that they all want to expand capacity, hire more people, and make more sales. Using the balance sheet, he can make the point that every dollar tied up in departments is money he doesn’t have for an expansion.
This CFO is highlighting why working capital is so important. People like to stockpile inventory “just in case” and give customers as long as they need to pay because it makes a good relationship with the customer. They don’t always realize the big-picture problems that result.
Managing Working Capital Example
One example of managing working capital is found in supermarkets. Supermarket customers pay cash immediately, but the market isn’t paying suppliers for 30-60 days.
The founders of Pick n Pay in South Africa were privy to this dynamic. They were successful because they offered low prices, yet they had the money come in before having to pay their bills.
They knew that they would have money sitting in their hands for an entire month at a time. They took that money and put it into the Foreign Exchange Market, buying and selling currencies. They made money that way, not by making a profit in the supermarket. They have grown to be the second largest supermarket chain in South Africa.
Why Is Working Capital Important?
Working capital is a tough figure to track. Fixed assets such as machinery are easy to price out, but working capital involves a revolving process consisting of many moving parts. Yet, it is essential for businesses to understand to make the best decisions.
Knowing what working capital is and how to manage it is part of having excellent financial acumen, which is key to running a successful company. Yet, most employees have a minimal understanding of basic financial concepts. So what can you do to ensure your employees have the financial acumen to make better business decisions? You train them! But, formal finance training can be boring and ineffective. That’s why we made Income|Outcome business simulations.
In our finance acumen training simulations, teams use a game board to maneuver through real-world situations. They make tough business decisions and learn how they impact the company. Our business simulations inspire, engage and create lasting behavioral change in participants.
Are you interested in building your team’s financial acumen? Contact us today!
Working capital is closely related to a company’s “cash flow forecast.” We’ve written about cash flow in detail here.
Great post!
I’ll send it on.