So this is what is called a “negative working capital model“. In the moment a company buys its inventory, it will record that amount on the Liabilities side of the Balance Sheet as Accounts Payable. Simultaneously, it will record on the Assets side of the Balance Sheet the same value as “Inventory”.

Let’s say that in the next month the company will sell all of those potatoes. The company still has that “debt” to pay to its supplier. It would be reasonable to think that the company would be willing to pay down that “debt” immediately. But if the company isn’t paying an interest on that “debt” why should it be paying its suppliers before those 90 days?

It will, of course, use that cash in the meantime by ordering more potatoes (or some other product). And the story repeats itself. It is only after selling the potatoes 3 times that the company will have to pay the first order to its supplier. This seems great. And it is!…. until it isn’t. But I’ll leave that to a later post in this series. 

All of this serves the purpose of explaining that calculating the working capital and the current ratio of a business isn’t simply a ratio calculation. It is used, or it should be used, to understand the business. And that’s why I find it so amusing to dig into a company’s financial statements.

Although the Working Capital formula is “Current Assets minus Current Liabilities”, I’m usually much more interested on the Non-cash-Working-Capital. It is calculated as “Inventory + Accounts Receivables – Accounts Payables”. Why aren’t we including the cash and the debt on this calculation? 

Because the cash isn’t being employed in the operations (well, maybe some of it might be) and the financial debt isn’t a fundamental part of the operation but a choice the management team has made. What I’m calculating here is just the operating working-capital regardless of how the business is funded. 

Different businesses have different working capital needs. An industrial business must buy the raw materials and transform them into finished goods prior to selling them. It will have a lot of cash tied up in this inventory whereas a small accounting company needs only to pay for the salaries of its employees and utility bills in the short-term. This difference in working-capital needs is crucial, not only to fully understand a business, but most importantly, to run the business. 

I remember that after a couple of years of working in a windows manufacturing company, a new management team came in and decided that the aluminium profiles that were used to assemble the window frames would only be ordered from the supplier when a deal was closed with a customer.

From that day on there wouldn’t be a huge inventory of aluminium profiles on the factory floor. This of course caused a lot of buzz because the project managers were used to having the profiles at hand whenever they needed them. This was called the Just-in-Case inventory strategy. 

The new strategy was called Just-in-Time or the Toyota Production System (because Toyota adopted that system in the 70’s).

And why did the new management make such a change? To reduce the working capital needs and free up the cash that was sitting in the factory floor as inventory waiting to be transformed. 

By this time you should be asking: “But what about a minimum inventory? Isn’t it fundamental?”. And you are right. The amount of working capital a company needs is a balancing act that needs fine tuning by the management team. 

Too much inventory and the profitability will decrease because the money that’s invested in inventory could be invested in something else like a new machine (CAPEX). Too little and the company might not be able to keep up with demand. The same happens with the payables and receivables. If the company gives good credit conditions to its customers it might suffer immediate cash-constraints. Maybe it should be asking its clients to pay earlier instead (or its suppliers to collect later).

There is no one-size-fits-all in what relates to working capital management. It varies from industry to industry and even from company to company within the same industry.

This was the first part in a series of posts on the Working Capital. In Part 2 I’ll be looking at the changes in working capital required to calculate the Cash from Operations and its influence in finding out the Free-Cash-Flow.