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What is Working Capital?

The Most Comprehensive Guide on Working Capital: Definitions, Components, Ratios and Examples

Key Takeaways

1. Working Capital Definition

Working Capital
Working capital is the cash tied up in the day-to-day activities of a business. More technically, the term working capital is often used as a generally accepted collective term for short-term balance sheet items, which comprise current assets and current liabilities.

The main current assets on a balance sheet are cash, accounts receivable, inventory and other current assets. Current liabilities, on the other hand, comprise short-term loans, accounts payables, current portion of long-term debt as well as other current liabilities. All components for working capital are located solely on the balance sheet. As illustrated in the picture below, the orange-shaded items constitute the working capital. Section 2 will describe them in more detail.

Working Capital - Current Assets Current Liabilities
Current Assets - Current Liabilities = Working Capital


Net Working Capital

The difference between current assets and current liabilities is called “Net working capital”. Net working capital is what most people imprecisely refer to as working capital.

If the current assets exceed current liabilities, the company has a positive net working capital. Positive working capital is usually preferred, as it means that there are sufficient current assets to pay off the current liabilities. A negative net working capital would typically mean that the business has to take on a short-term loan or overdraft their bank account to pay their short-term liabilities. However, some companies have a large amount of negative net working capital and are, at the same time, benefitting from it. We will discuss this issue in section 4.

Operating Working Capital
For corporate finance and also for financial modeling purposes, there is another crucial working capital metric, the “operating working capital”. The (net) operating working capital is defined as the difference between non-cash current assets and non-interest-bearing current liabilities. In other words, the current assets without the cash and cash-like items, less the current liabilities without the debt.

Operating Working Capital Definition
Operating Working Capital

Working capital is the cash tied up in the day-to-day activities of a business

2. Description of Working Capital Accounts

2.1. Current Assets

Cash and Cash Equivalents
Cash describes a currency that is available on the bank accounts of a company. Cash equivalents are all current assets that can quickly be transferred into cash, such as money market funds, short-term bonds and commercial paper.

Accounts Receivable
An accounts receivable position includes all credit sales where the customer pays for a product or service at a future point of time. Once the customer pays the invoice, the accounts receivable position decreases again.

Inventory
The balance sheet position inventory contains all raw materials, work-in-progress and finished goods that are ready for sale or consumption.

As an example: When a company purchases oranges to produce orange juice, the oranges are inventory to the company. Once the company produces the juice and sells it to customers, the inventory position will decrease by the value of the oranges consumed.

Other current assets
Other current assets can be, amongst others, prepaid expenses or deferred tax. A prepaid expense is a current asset for the payment of a cost before it is invoiced.

Let’s assume that the company was so happy with the oranges of this season that it already ordered and paid oranges for the upcoming season. The pre-purchase would decrease the cash position on the balance sheet, while prepaid expenses would increase by the same amount. Effectively, there would be no net change on the balance sheet as one asset declines while the other increases.

2.2. Current Liabilities

Accounts payable
Accounts payable are short-term obligations that the company owes to its suppliers. If the company of our earlier example buys its oranges on credit as opposed to cash, accounts payable on the balance sheet increases. 

Short-term debt
Short term debt refers to the portion of the financial debt that comes due within twelve months. For example, this could be a revolving credit facility used for funding short-term working capital needs. Moreover, it can also be maturing long-term debt, which is then labeled as “current portion of long-term debt”.

Accrued liabilities
Other current liabilities consist of, for example, accrued liabilities as well as deferred tax liabilities.

Accrued liabilities is the balance sheet position of expenses that have been incurred but where the invoice has not yet been received. Most of the time, the accrued liability position is only an estimate of the costs, and the actual value will likely differ. An example would be a utility bill (gas, water, electricity). The company incurs costs over a period of time, but the actual invoice will only be received at the end of the utility period. Once the company gets the invoice, the accrued liability position will turn into accounts payable until payment occurs.

A deferred tax liability exists due to the difference between tax and accounting methods.

3. The Importance of Working Capital Management

For a long time, businesses have not allocated sufficient time and effort to working capital management. That dramatically changed over the last decade, as many companies are now employing staff that solely focusses on optimizing working capital.

3.1. The Traditional View of Working Capital

The traditional view of working capital management was that positive working capital is something to strive for. Companies thought that the higher their working capital is, the better they are perceived. This thinking came from the fact that financial analysts and banks were looking at working capital ratios from the perspective that the higher the current assets of the company, the better they can cover their short-term liabilities. While this is true, excess net working capital comes at a cost for the company.

3.2. The Modern View of Working Capital

The modern view of working capital differs largely from the traditional view. Let us have a look at what “having a large positive net working capital” actually means. If we look at the current assets of the balance sheet, we mainly have cash, inventory and accounts receivable. So, a positive net working capital means that the company has either vast cash reserves, a large inventory or a high sum of accounts receivables (or all three combined) that stand against the current liabilities. While the company might be in an advantageous position to be able to cover all their short-term liabilities, they also have a lot of cash tied up to their balance sheet that can’t be used for any other business or investing activities. A company can’t generate returns from capital that is tied up in raw materials or finished goods in the inventory, nor from cash that it awaits from its customers. Instead of the cash sitting on the balance sheet and representing an opportunity cost to the company, it could have invested it in other business activities. Consequently, there is a particular cost for businesses carrying high net working capital.

As companies changed their view towards the modern way of looking at working capital, they started trying to keep net working capital at the necessary minimum required to operate the business. As companies are trying to be as efficient as possible nowadays, working capital management has become an essential discipline, and jobs were created that solely focus on optimizing working capital.

3.3. Bringing Working Capital Management into Perspective

To bring the importance of working capital management into perspective, let’s look at two working capital studies from PWC[1] and EY.[2]

In its 2019/20 working capital study, PWC estimated net working capital globally to be at the level of €4.2 trillion in 2018 and drastically growing year-over-year. Of the €4.2 trillion, PWC is predicting that €1.2 trillion can be released through better working capital management.

In a similar study that, however, only focussed on 1,500 leading US and European companies, EY indicated that these companies might have excess working capital – so above the required minimum to operate the business – of USD 2.5 trillion. On average, the companies had net working capital equivalent to 10% of their annual sales, according to EY.

These figures illustrate that there is still massive potential for companies to enhance their working capital management.

4. Positive vs. Negative Working Capital

In the previous section, we have found out that a high (net) working capital is not always what companies consider best practice. Let’s now have a more in-depth view of positive vs. negative working capital.

4.1. Positive Working Capital

A high net working capital can also point towards a more deep-rooted problem in the payment terms of the company. On the one hand, a large amount of accounts receivable can mean that the company continually sells a good number of products or services, or, on the other hand, that the payment terms they offer their customers are far too relaxed. The latter can be measured by the days sales outstanding, which track the average number of days it takes the company to collect the payments from its customers. This metric is influenced by (i) the payment terms the company gives to its customers, and (ii) the effort it puts into receivables management. If a company tends to be somewhat negligent when it comes to reminding its customers to pay on time, the customers might use that fact to their advantage by optimizing their working capital management.

What’s more, a high net working capital can result from poor inventory management. As mentioned earlier, inventory comprises raw materials, work-in-progress as well as finished goods. While a company needs to have enough materials and goods in stock to avoid product shortage, it needs to make sure that inventory gluts are kept at a minimum as well. That is an especially challenging task when facing complex supply chains.

4.2. Which Companies Tend to Have Highly Positive Working Capital?

When it comes to specific key performance indicators of working capital, pharma is topping the list of the worst-performing industries. But why is that?

In general, pharma companies tend to have inventory gluts. The reasons for that are twofold. Most of the products they sell have high margins, and they can’t or don’t want to miss out on large orders. Furthermore, often end consumers, i.e. patients, depend on the products and have a vital need for it. It is hard to justify optimizing working capital when lives are on the line.

Moreover, pharma companies need to make sure that they comply with all the different regulations across different countries. That also includes the labeling of their products. The additional complexity leads to more extensive inventory stocks. Another factor is that pharma companies are highly regulated. Strict quality controls and procedures often add several weeks to their manufacturing chains. There are many more complexities the pharma industry is facing, but the point should be clear.

For an overview of more industries with highly positive working capital, please refer to the section working capital ratios below.

4.3. Negative Working Capital

Let’s now take a look at the liability side of working capital. Similar to waiting too long until collecting receivables, companies can have too short payment terms to their suppliers. In terms of working capital management, it is beneficial for the business to pay as late as possible. That way, the company can use the funds for other operating or investing activities. A company that optimizes its payable management can benefit from stable operating cycles and maintain healthy liquidity. In the extreme, if a business negotiated extraordinarily good payment terms while collecting its receivables in a timely manner, net working capital can turn negative. In that example, negative net working capital is beneficial to the business. Supermarkets would be an example of such a case.

Nevertheless, negative net working capital can, of course, also be disadvantageous. Imagine an apparel retail store during the Covid-19 lockdowns. While the stores have stocked up with clothes, they suddenly had to close down and were not able to sell any of their goods. However, they still had to pay their suppliers next to all the remaining operating costs like rent and salaries. Consequently, the operational cash was consummated quickly, followed by many invoices becoming due. As a result, their net working capital turned negative, effectively resulting in their short-term assets not being able to cover their short-term liabilities.

4.4. Which Companies Usually Have a Highly Negative Working Capital?

Some industries are known for having negative net (operating) working capital while benefitting from it. Such an example is the fast-moving consumer goods (“FMCG”) sector. Their products are often sold from the shelves in cash before they pay their suppliers. Further, they can keep inventory low and might, due to their size, negotiate favorable payment terms with their suppliers.

Imagine a company that sells groceries. While the company purchases the goods on credit with a 30 days payment term, the products might already be sold a few days after they got delivered. Effectively, that means that the company got an interest free loan for the remaining month and did not need to keep vast cash reserves. If we look at, for example, Walmart from fiscal years ending January 2016 to 2020, their net operating working capital averaged a negative USD15.5 billion, with a peak of negative USD7.1 billion. For Walmart, this is a sign of efficiency rather than liquidity shortage.

For a detailed overview of the working capital averages of different industries, we have created a detailed overview in section 6. You can find further resources on different industry WC ratios here.

5. What Can Companies Do to Improve Their Working Capital Management?

PWC has listed in its Working Capital Report 2019/20[1] a range of improvements a company can undertake to enhance its working capital management and unlock tied up cash.

In general, they found out that companies that use new and advanced digital technology unlock more cash and hence create more value than their peers that don’t. For example, data analytics can help companies to achieve transparency when it comes to cash performance. Moreover, artificial intelligence, cloud-based solutions and robotic process automation can further help in unlocking cash.

Below are the activities that PWC listed that can help to improve a company’s working capital management

How to Improve Working Capital
Source: PWC Working Capital Report 2019/2020

6. Working Capital Ratios

6.1. What Is the Working Capital Cycle?

Operating Cycle

Working Capital - Operating Cycle

To understand what a working capital cycle is, let’s first look at the operating cycle of a company. The operating cycle starts when the business purchases raw materials. It then transforms the raw materials into final products. Once the products are ready, they can be sold to customers, and the business receives a payment at some point in time. But where exactly in that process is cash tied up? The working capital cycle, or also referred to as the cash conversion cycle, provides an answer to this question, as follows below.

Working Capital Cycle / Cash Conversion Cycle

Working Capital - Cash Conversion Cycle

Accounts payable period
Before a company can start manufacturing its products, it needs to order raw materials. However, companies usually do not pay upon delivery. The delay between the shipping of the raw materials and the actual payment is called accounts payable period or days payable outstanding (“DPO”).

Inventory period
The period from the moment of delivery of the raw materials until the finished goods are sold and leave the inventory, is called days inventory outstanding (“DIO”).

Accounts receivables period
And lastly, the period from the sale of the product until the customer pays is called the accounts receivable period or days sales outstanding (“DSO”). Remember: Customers might receive an invoice that allows them to pay in a period up until a certain due date, so they don’t necessarily need to pay at the moment they receive the product.

Working capital cycle / Cash conversion cycle
From the moment the company has to pay for the raw materials until it receives the payment from its customers, cash is tied up. That period is called the cash conversion cycle. To put it into a formula:

Cash Conversion Cycle Formula WC

Working capital management is to reduce the number of inventory days and receivable days while prolonging the payable days. The shorter the cash conversion cycle, the more liquidity is available.

6.2. Working Capital Days – Calculating Days Payables Outstanding

Days payables outstanding (“DPO”) is the average number of days it takes a company to pay its suppliers. The calculation looks as follows:

Working Capital Days - Days Payables Outstanding Formula DPO

The formula takes the average accounts payable and divides them by the direct costs (COGS) of the company and then multiplies it with the number of days of the period under consideration. In most cases, this is going to be a full year. If the average of accounts payable over the period is not available, you can also take the period’s end figure from the balance sheet. However, make sure that the company you are looking at has no seasonality in accounts payables.

6.3. Working Capital Days – Calculating Days Inventory Outstanding

Days inventory outstanding (“DIO”) is the average number of days raw materials and later on finished goods stay in the inventory of the company before being sold.

Working Capital Days - Days Inventory Outstanding Formula DIO

The formula takes the average inventory and divides it by the direct costs of the company and then multiplies it with the number of days in the period. If the average inventory is not available, again, take the year’s end inventory balance from the balance sheet. If you, for example, look at a retailer with the accounting year ending 31 December, you will probably have a much lower inventory balance compared to the average as they might have sold their entire stock during the Christmas period. Therefore, make sure seasonality is not affecting your calculation.

6.4. Working Capital Days – Calculating Days Sales Outstanding

Days sales outstanding (“DSO”) is the average number of days it takes a company to collect payments from its customers.

Working Capital Days - Days Sales Outstanding Formula DSO

The formula takes the average accounts receivables and divides it by the revenue of a period and then multiplies it with the number of days of the same period. Again, make sure there are no fluctuations in the accounts receivables when taking the period’s end figure.

6.5. How to Calculate Working Capital Days?

If you have calculated days payables outstanding, days inventory outstanding and days sales outstanding as explained above, calculating working capital days is now straight-forward.

Working Capital Days Formula DIO+DSO-DPO

6.6. What Are Average DSO, DPO and DIO Metrics?

The chart below shows the average days sales outstanding, days payables outstanding and days inventory outstanding across all industries for companies globally over the years 2014 to 2018.[1]

Average days sales outstanding, days inventory outstanding and days payable outstanding for different industries
Data source: PWC Working Capital Report 2019/2020

6.7. DSO, DPO and DIO for Different Industries

Both the chart, as well as the data table below, show the median days sales outstanding, days payables outstanding and days inventory outstanding for different industries.

Average DSO, DIP, DPO for different industries
Average DSO, DIP, DPO for different industries table
Data source: PWC Working Capital Report 2019/2020

6.8. The Current Ratio & Quick Ratio

The current ratio and quick ratio are both very easy-to-calculate liquidity ratios that concern the working capital of a business.

Working Capital - Current Ratio & Quick Ratio

The current ratio is a measurement of a company’s short-term liquidity to cover short-term obligations. It divides all the current assets by current liabilities.

The quick ratio further eliminates inventory from the equation. The reason for that is that inventory is not considered to be “quickly” turned into cash. Therefore, the quick ratio only considers cash & cash equivalents as well as accounts receivables.

A quick ratio of above 1 means that the company has more of the most liquid current assets than current liabilities and is, therefore, in a strong position to pay off its current liabilities in a timely manner. Vice versa, a quick ratio of below 1 would mean that the company might fall short of liquidity to pay off its short-term obligations.

7. Working Capital Adjustment Mechanisms in M&A Transactions

M&A transactions usually follow either the closing accounts or the locked box mechanism. Both mechanisms concern purchase price adjustments – the key difference is the point of time of the economic transfer and the working capital adjustment related thereto.

To keep it short: In a locked box mechanism, the buyer offers a purchase price based on a historical balance sheet (the “locked box balance sheet”). That means the economic transfer of the company – so the point where the buyer is entitled to the profit and loss of the business – takes place retroactively at the time of the locked box balance sheet. Consequently, the buyer and seller are already aware of the working capital as of economic transfer, and there will subsequently be no adjustments as of closing.

However, it looks slightly different when the transaction follows the closing accounts mechanism. In a closing accounts mechanism, the economic transfer happens at the point of closing, not retroactively at the date of the balance sheet. When an M&A transaction includes conditions that need to be fulfilled before an effective completion of the deal, signing and closing do not take place at the same point in time. In that case, the closing – and hence the entitlement to the profits – is delayed. A possible closing condition is, for example, the approval from antitrust authorities.

At the same time, a buyer’s offer usually excludes cash and debt but includes a normalized level of operating working capital. That means that (non-operational) cash will be added on top of the enterprise value offered, while interest-bearing debt items (current and long-term) will be deducted. The normalized operational working capital is usually included in the enterprise value offered as it plays an integral part in the operations of the company, and realizing revenues would not be able without it.

As the operating working capital is included in the purchase price, but the cash position will be added on top, sellers would try to liquidate all their non-cash current assets as quickly as possible and defer their current liabilities to a point after the economic transfer. That risk is prevented by way of agreeing on a target working capital for the time when the economic transfer happens and adjusting the purchase price (in both directions) when the working capital differs from that target.

[1] – PricewaterhouseCoopers (PWC). “Working Capital Report 2019/20: Creating value through working capital”, https://www.pwc.com/gx/en/working-capital-management-services/assets/working-capital-report-final.pdf.” Accessed June 3, 2020.

[2] – Ernst & Young (EY). „All tied up – Working capital management report 2019, https://assets.ey.com/content/dam/ey-sites/ey-com/en_gl/topics/transaction-advisory-services/transactions-pdfs/ey-working-capital-report-2019.pdf?download.” Accessed June 3, 2020.