# Working Capital

Guide to Understanding Working Capital

## Working Capital Formula

A key part of financial modeling involves forecasting the balance sheet.

Working capital refers to a specific subset of balance sheet items. The simplest definition of working capital is shown below:

Working Capital = Current Assets Current Liabilities
• What makes an asset current is that it can be converted into cash within a year.
• What makes a liability current is that it is due within a year.
 Current Assets Current Liabilities Accounts payable Accrued expenses Deferred revenue Short term debt Current portion of long-term debt

## Working Capital: Balance Sheet Example

As a working capital example, here’s the balance sheet of Noodles & Company, a fast-casual restaurant chain. As of October 3, 2017, the company had \$21.8 million in current assets and \$38.4 million in current liabilities, for a negative working capital balance of -\$16.6 million:

## Current Ratio and Quick Ratio

A financial ratio that measures working capital is the current ratio, which is defined as current assets divided by current liabilities and is designed to provide a measure of a company’s liquidity:

As we’ll see shortly, this ratio is of limited use without context, but a general view is that a current ratio of > 1 implies a company is more liquid because it has liquid assets that can presumably be converted into cash and will more than cover the upcoming short-term liabilities.

Another closely related ratio is the quick ratio (or acid test) which isolates only the most liquid assets (cash and receivables) to gauge liquidity. The benefit of ignoring inventory and other non-current assets is that liquidating inventory may not be simple or desirable, so the quick ratio ignores those as a source of short-term liquidity:

## Working Capital Presentation on Cash Flow Statement (CFS)

The balance sheet organizes assets and liabilities in order of liquidity (i.e. current vs long-term), making it very easy to identify and calculate working capital (current assets less current liabilities).

Meanwhile, the cash flow statement organizes cash flows based on whether items are operating, investing, or financing activities, as you can see from Noodles & Co.’s cash flow statement below:

## Reconciling Working Capital on the Balance Sheet with CFS

The balance sheet organizes items based on liquidity, but the cash flow statement organizes items based on their nature (operating vs. investing vs. financing).

As it so happens, most current assets and liabilities are related to operating activities[1] (inventory, accounts receivable, accounts payable, accrued expenses, etc.) and are thus primarily clustered in the operating activities section of the cash flow statement under a section called “changes in operating assets and liabilities.”

Because most of the working capital items are clustered in operating activities, finance professionals generally refer to the “changes in operating assets and liabilities” section of the cash flow statement as the “changes in working capital” section.

However, this can be confusing since not all current assets and liabilities are tied to operations. For example, items such as marketable securities and short-term debt are not tied to operations and are included in investing and financing activities instead (although in the above example, Noodles & Co happened to not have any marketable securities or short-term debt).

## Operating Items vs. Working Capital on the Cash Flow Statement

Adding to the confusion is that the “changes in operating activities and liabilities” (often called the “changes in working capital”) section of the cash flow statement commingles both current and long-term operating assets and liabilities. That’s because the purpose of the section is to identify the cash impact of all assets and liabilities tied to operations, not just current assets and liabilities.

For example, Noodles & Co classifies deferred rent as a long-term liability on the balance sheet and as an operating liability on the cash flow statement[2]. It is thus not included in the calculation of working capital, but it is included in the “changes in operating activities and liabilities” section (which we now know people often also refer to, confusingly, as “changes to working capital”).

## Working Capital on Financial Statements

Below we summarize the key takeaways we’ve described from the presentation of working capital on the financial statements:

• While the textbook definition of working capital is current assets less current liabilities, finance professionals also refer to the subset of working capital tied to operating activities as simply working capital. Welcome to the magical world of finance jargon.
• The balance sheet working capital items include both operating and nonoperating assets and liabilities whereas the “changes in working capital” section of the cash flow statement only includes operating assets and liabilities and
• The cash flow statement’s informally named “changes in working capital” section will include some noncurrent assets and liabilities (and thus excluded for the textbook definition of working capital) as long as they are associated with operations.

## How to Interpret Working Capital

Now that we’ve addressed how working capital is presented, what does working capital tell us?

Let’s continue with our Noodles & Co example.

• What does the company’s negative \$16.6 million working capital balance tell us?

For starters, it tells us that there are \$16.6 million more liabilities coming due over the next year than assets that can be converted within the year. This might seem like a troubling metric.

For example, if all of Noodles & Co’s accrued expenses and payables are due next month, while all the receivables are expected 6 months from now, there would be a liquidity problem at Noodles. They’d need to borrow, sell equipment or even liquidate inventory.

But the same negative working capital balance could be telling a completely different tale, namely of healthy and efficient working capital management, where accounts payables, accounts receivable and inventory are carefully managed to ensure that inventory is quickly sold and cash is quickly collected, allowing Noodles & Co to pay invoices as they come due and purchase more inventory without tying up cash and without skipping a beat.

Further, Noodles & Co might have an untapped credit facility (revolving credit line) with sufficient borrowing capacity to address an unexpected lag in collection.

In fact, here’s how Noodles & Co explains their negative working capital in the same 10Q:

“Our working capital position benefits from the fact that we generally collect cash from sales to customers the same day, or in the case of credit or debit card transactions, within several days of the related sale, and we typically have up to 30 days to pay our vendors. We believe that expected cash flow from operations, the proceeds received from the private placement transactions and existing borrowing capacity under our credit facility are adequate to fund debt service requirements, operating lease obligations, capital expenditures, the Restaurant Closing Liabilities, the Data Breach Liabilities and working capital obligations for the remainder of fiscal year 2017.”

In short, the amount of working capital on its own doesn’t tell us much without context. Noodle’s negative working capital balance could be good, bad or something in between.

## Working Capital Metrics: Formula Chart

Cash, accounts receivable, inventories and accounts payable are often discussed together because they represent the moving parts involved in a company’s operating cycle (a fancy term that describes the time it takes, from start to finish, of buying or producing inventory, selling it, and collecting cash for it).

For example, if it takes an appliance retailer 35 days on average to sell inventory and another 28 days on average to collect the cash post-sale, the operating cycle is 63 days.

In other words, there are 63 days between when cash was invested in the process and when cash was returned to the company. Conceptually, the operating cycle is the number of days that it takes between when a company initially puts up cash to get (or make) stuff and getting the cash back out after you sold the stuff.

Since companies often purchase inventory on credit, a related concept is net operating cycle (or cash conversion cycle), which factors in credit purchases. In our example, if the retailer purchased the inventory on credit with 30-day terms, it had to put up the cash 33 days before it was collected. Here, the cash conversion cycle is 35 days + 28 days – 30 days = 33 days. Pretty straightforward.

Below is a summary of the formulas required to calculate the operating cycle described above:

## Working Capital Management: Operating Efficiency

For many firms, the analysis and management of the operating cycle is the key to healthy operations. For example, imagine the appliance retailer ordered too much inventory – its cash will be tied up and unavailable for spending on other things (such as fixed assets and salaries).

Moreover, it will need larger warehouses, will have to pay for unnecessary storage, and will have no space to house other inventory.

Imagine that in addition to buying too much inventory, the retailer is lenient with payment terms to its own customers (perhaps to stand out from the competition). This extends the amount of time cash is tied up and adds a layer of uncertainty and risk around collection.

Now imagine our appliance retailer mitigates these issues by paying for the inventory on credit (often necessary as the retailer only gets cash once it sells the inventory).

Cash is no longer tied up, but effective working capital management is even more important since the retailer may be forced to discount more aggressively (lowering margins or even taking a loss) to move inventory in order to meet vendor payments and escape facing penalties.

Taken together, this process represents the operating cycle (also called the cash conversion cycle). Companies with significant working capital considerations must carefully and actively manage working capital to avoid inefficiencies and possible liquidity problems. In our example, a perfect storm could look like this:

1. Retailer bought a lot of inventory on credit with short repayment terms
2. Economy is slow, customers aren’t paying as fast as was expected
3. Demand for the retailer’s product offerings change and some inventory flies off the shelves while other inventory isn’t selling

In this perfect storm, the retailer doesn’t have the funds to replenish the inventory that’s flying off the shelves because it hasn’t collected enough cash from customers. The suppliers, who haven’t yet been paid, are unwilling to provide additional credit, or demand even less favorable terms.

In this case, the retailer may draw on their revolver, tap other debt, or even be forced to liquidate assets. The risk is that when working capital is sufficiently mismanaged, seeking last-minute sources of liquidity may be costly, deleterious to the business, or in the worst-case scenario, undoable.

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## Working Capital Exercise – Excel Template

We’ll now move to an illustrative working capital example of Noodles & Co.

Submitting ...

## Working Capital Calculation Example

While our hypothetical appliance retailer appears to require significant working capital investments (translation: It has cash tied up in inventory and receivables for 33 days on average), Noodles & Co, for example, has a very short operating cycle:

We can see that Noodles & Co has a very short cash conversion cycle – less than 3 days. It takes roughly 30 days to convert inventory to cash, and Noodles buys inventory on credit and has about 30 days to pay. This explains the company’s negative working capital balance and relatively limited need for short-term liquidity.

## Summary of Working Capital Management

The section above is meant to describe the moving parts that make up working capital and highlights why these items are often described together as working capital. While each component (inventory, accounts receivable and accounts payable) is important individually, together they comprise the operating cycle for a business, and thus must be analyzed both together and individually.

Working capital as a ratio is meaningful when it is compared, alongside activity ratios, the operating cycle and the cash conversion cycle, over time and against a company’s peers. Taken together, managers and investors gain powerful insights into the short-term liquidity and operations of a business.

## Working Capital Schedule in Financial Modeling

When it comes to modeling working capital, the primary modeling challenge is to determine the operating drivers that need to be attached to each working capital line item.

As we’ve seen, the major working capital items are fundamentally tied to the core operating performance, and forecasting working capital is simply a process of mechanically linking these relationships. We describe the forecasting mechanics of working capital items in detail in our balance sheet projections guide.

###### Footnotes

[1] Notice that cash is missing. At the risk of stating the obvious, that’s because cash is the very thing the cash flow statement is trying to solve for.

[2] Under US GAAP, companies can choose to account for leases as operating or capital leases. When leases are accounted for as operating leases, lease (rent) payments are treated as operating expenses like wages and utilities: Regardless of whether you sign a 1-year lease or a 30-year lease, every time you pay the rent, cash is credited and an operating expense is debited.

As a side note, this is a conceptually flawed way to account for long term leases because leases usually burden the tenant with obligations and penalties that are far more similar in nature to debt obligations than to a simple expense (i.e. tenants should present the lease obligation as a liability on their balance sheet as they do long term debt). In fact, the option to account for leases as operating lease is set to be eliminated starting in 2019 for that reason. But for now, Noodles & Co, like many companies do it because it prevents them from having to show a debt-like capital lease liability on their balance sheets.

So, if Noodles accounts for leases as operating leases, what’s this deferred rent liability all about?  It is simply an accounting adjustment to match rent payments to when the tenant has already occupied the space. For example, if a tenant signs a 5-year lease, with a \$50,000 monthly lease payment and gets the first month free, accounting rules dictate that a rent expense still be recognized in the first month in the amount of the total of all monthly rent payments over the 5 years divided by 59 months (\$2.95 million / 60 months = \$49,167.  Since you don’t actually pay anything in the first month but recognize the \$49,167 expense, a deferred rent liability in the amount of \$49,167 is also recognized (and declines by \$833 evenly over the next 59 months until the liability is eliminated at the end of the lease.  Since the lease is 5 years, it is a recognized as a long-term liability.

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Inline Feedbacks
Yohann
March 17, 2019 8:30 am

Oh and in the second footnote: is it “\$2.95mm/60 months” or “\$2.95mm/59 months” ? Because you write “divided by 59 months”, but you divide by 60 months in your calculation. Maybe there is something I did not grasp?

Many thanks

Yohann

Chris Byers
January 19, 2021 3:57 am

Linda
January 4, 2021 9:46 pm

This is a very good article. Thank you for sharing. I look forward to publishing more such works. There are not many such articles in this field.

Yohann
March 17, 2019 8:25 am

Hey I think I’ve spotted 3 typos: (1) “The benefit of ignoring inventory and other *non-current* assets is that liquidating inventory may not be simple or desirable…” –> should read: “and other *current* assets” ? (2) “Adding to the confusion is that the ‘changes in operating *activities* and liabilities’…” –>… Read more »

Oliver
February 15, 2023 5:04 am

You article is very valuable for me. Hoping to read more. Thank you.

X

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