WHAT IS WORKING CAPITAL?

INTRODUCTIONWHAT IS WORKING CAPITAL?In earlier units, we studied capital markets and capital budgeting. Then, the focus was on longer term investing and the financing of those investments. In this unit, we turn our attention to the money needed to run the business daily. If you can appreciate the dilemma of having to pay for the raw materials and labor that go into your product long before you actually sell it and collect the money from that sale, you will understand the role of working capital.Working capital is simply the short-term capital needed to run the business day-to-day-that is to pay the bills, make your products, and run your business. We are generally talking about short-term assets like cash in the bank, short-term investments (also known as near-cash), inventory, and accounts receivable. When you deduct the short-term liabilities (such as accounts payable, accrued payroll, and the short-term portion of long-term debt), then you have net working capital.THE IMPORTANCE OF NET WORKING CAPITALThough it may seem more tactical and therefore less glamorous than the strategic nature of long-term investments, financial managers (and managers in general) spend most of their time on the daily business operation. As someone once said, “If you don’t get the short term right, then the long term doesn’t matter.”One way to determine the health of a company is to look at the net working capital. If it is negative, chances are that the company might not be able to cover its near-term obligations from readily available funds. From the work you did on financial ratio analysis, this would manifest in a current ratio of less than 1.0.The company may have to raise some additional working capital to remain solvent. Yet as sound as this may seem, consider the recent trend toward zero working capital. Money that is owed you but not received or inventory that has been paid for but not sold is not really very useful, yet this is what working capital is (along with cash in the bank, which also is not really a great investment). Therefore, the more recent theory is that companies should minimize working capital, even to the point where net working capital is negative—this is a good thing to have.HOW DO YOU GET NEGATIVE NET WORKING CAPITAL?If you think about what net working capital is, it becomes clear how to minimize it:CashYou should not have any more cash or cash equivalents than you need for things like compensating balances (for example, the cash banks may require if you take a loan, avoiding service charges) and meeting immediate commitments. You can usually borrow for temporary spikes in cash demand.Accounts ReceivableIdeally, have your customer pay in advance or at the same time as shipped. If you cannot get payment until after the sale (which is usually the case), then provide trade credit terms that provide an incentive for early payment. Example: 2/10, net 30 means the customer gets a 2% credit if paid within 10 days or else the total amount is due in 30 days. Essentially you are charging 2% interest for 20 days—pretty substantial, but not uncommon in many industries. This will get the money in sooner and therefore reduce the accounts receivable. (Of course, this is a double-edged sword in that you are giving up a lot of the invoice just to get the money in a little earlier).