Part 1, Lesson 9

Overview

The definition of working capital is:

Working Capital = Current Assets – Current Liabilities

Working capital is the amount of capital a business needs to function in its day to day operations.  The focus is on current assets and liabilities (less than 12 months) since these are the items most relevant for the functioning of a business on a near-term basis.

A company is said to have positive working capital if its current assets exceed its current liabilities, and conversely, a company with current assets that are less than current liabilities is said to have negative working capital.

Let’s return to our Verizon balance sheet and calculate their working capital:

We have highlighted in the red box Verizon’s current assets and current liabilities.  Verizon’s current assets include its cash, accounts receivable, inventories, assets held for sale, and prepaid expenses.  Verizon’s current liabilities include debt maturing in one year, accounts payable, and “other” current liabilities.

The Dec 31, 2017 working capital balance for Verizon is \$29,913 – \$33,037 = (\$3,124).

This shows that Verizon has a negative working capital balance of approximately \$3 Billion.  The reason why analysts pay attention to working capital is to determine if a business will ultimately need to invest more capital in its business to fund working capital.  In Verizon’s example, if Verizon were to liquidate all its current assets and all its current liabilities, it would be on the hook for \$3 Billion.  In reality, Verizon is not likely to ever need to liquidate all its current assets and liabilities, but investors will want to know if a \$3Bn working capital deficit is sustainable or if Verizon will need to deploy more working capital (which would be a cash outflow for the company).

For example, if (hypothetically) Verizon had temporarily stretched its accounts payable (by not paying vendors) while simultaneously pushing customers to pay their bills on time (reducing accounts receivable), this could result in negative working capital.  But ultimately, those accounts payable bills come due and Verizon will have a cash need to make up for its negative working capital balance.

On the other hand, if Verizon is able to permanently pay vendors under a slower timeframe than it collects money from customers (which is probably true), then, Verizon can operate with negative working capital for a very long time.

Operating Working Capital

More often than not, when investors discuss working capital, they are often referring to a narrower definition of working capital, shown below:

Working Capital = Accounts Receivable + Inventory – Accounts Payable

This is because A/R, Inventory, and A/P are the key operating accounts affected by the purchase and sale of goods and the associated collection and payment of cash.  It is important to not get too hung up on the exact definition of operating working capital.  This definition could be slightly different for different companies or different industries depending on what is deemed to be a relevant working capital account for a particular business.

Let’s work through an example:

 Year 1 Year 2 Year 3 Year 4 A/R – Company A \$100 \$120 \$140 \$160 A/R – Company B \$100 \$110 \$120 \$130

In the above table, we are showing the accounts receivable line for two different companies.  Let’s assume that both companies have equal revenues.

We can see here that Company A accounts receivable is moving up by \$20 each year while Company B accounts receivable is moving up by \$10 per year.  All else being equal, which company would you rather invest in?

Company B is in a more enviable cash position than Company A.  This is because more and more of Company A’s sales are being tied up in accounts receivable.  By the end of Year 4, Company B has collected \$30 more cash from its sales than Company A.

Accounts receivable is one component of working capital, but we can see from this example how an increasing level of accounts receivable (and thus an increasing level of working capital) is a drain on the cash flow of a company.

Let’s now add in inventory:

 Year 1 Year 2 Year 3 Year 4 A/R – Company A \$100 \$120 \$140 \$160 Inventory – Company A \$50 \$55 \$60 \$65 A/R – Company B \$100 \$110 \$120 \$130 Inventory – Company B \$50 \$50 \$50 \$50

Company A is investing \$5 more in inventory every year, whereas Company B has not increased the amount of inventory it is maintaining.  If everything else is the same, which company would you rather invest in?

Again, we’d rather invest in Company B because Company A is having to deploy more cash every year into inventory just to maintain the same level of sales as Company B.  By the end of Year 4, Company A has spent \$15 more cash to purchase additional inventory, while Company B has generated the same sales without having to tie up more cash in inventory.

In this example, Company B is again in a more enviable cash position vs. Company A since Company B has had less cash invested into working capital.

Let’s now add in accounts payable:

 Year 1 Year 2 Year 3 Year 4 A/R – Company A \$100 \$120 \$140 \$160 Inventory – Company A \$50 \$55 \$60 \$65 A/P – Company A \$40 \$35 \$30 \$25 A/R – Company B \$100 \$110 \$120 \$130 Inventory – Company B \$50 \$50 \$50 \$50 A/P – Company B \$40 \$45 \$50 \$55

Company A starts with an accounts payable balance of \$40, but it’s A/P balance is decreasing by \$5 every year, which means it is having to spend \$5 more in cash every year to reduce its A/P balance.  Remember from our cash flow statement lesson, a reduction in a liability is a use of cash.

Company B, however, is moving in the opposite direction with its A/P balance, which goes up by \$5 every year.  This results in Company B not having to paydown its A/P balance as fast as Company A.  By the end of Year 4, Company A has spent \$30 more in cash to paydown A/P balances vs. Company B.

Once again, Company B is in a more enviable cash position than Company A.

Let’s now calculate Working Capital and Change in Working Capital:

 Year 1 Year 2 Year 3 Year 4 Accounts Receivable – Company A \$100 \$120 \$140 \$160 Inventory – Company A \$50 \$55 \$60 \$65 Accounts Payable – Company A \$40 \$35 \$30 \$25 Working Capital \$110 \$140 \$170 \$200 Change in Working Capital (Co. A) \$30 \$30 \$30 Accounts Receivable – Company B \$100 \$110 \$120 \$130 Inventory – Company B \$50 \$50 \$50 \$50 Accounts Payable – Company B \$40 \$45 \$50 \$55 Working Capital \$110 \$115 \$120 \$125 Change in Working Capital (Co. B) \$5 \$5 \$5

Company A and Company B both start off with \$110 of net working capital.  However, each year, Company A’s working capital balance increases by \$30.  On the other hand, Company B’s working capital balance only increases \$5 each year.

Since Company A is increasing working capital by \$30 per year, this results in a larger reduction of cash flow due to working capital needs when compared to Company B.  Remember: an increase in working capital is a cash outflow for the company.

When analyzing public company balance sheets, it will be important to incorporate working capital changes to get a complete sense of the cash flow generation of the business.