What is capital
Capital refers to total investment in a business. This capital has usually two components, one is the equity and second is the debt. The equity is owner’s own money invested in the business and debt is the amount of money borrowed by the business (in terms of long term debt or bank loans or bonds or debentures etc).
What is working capital
Now, it is important to understand that working capital is the money taken from the capital and then invested in certain items. Working capital is actually the allocation of the capital in specific assets.
So, the amount of the capital invested in inventories and receivables (netted off by the payables) is called working capital. It is referred to as working capital because this part of the capital would be continuously in the working (or rotating) cycle. The inventories will be sold to customers and customers will pay, this money will be used to pay to creditors and new inventories will be purchased. Thus a cycle of work will continue. The ‘work’ in this scenario refers to core functions of the business i.e., buying goods on credit from suppliers, holding the inventory till it is sold to the customers and then collecting the money from customers against sales. This is the core work of a business. Thus, an investment on this core cycle of the business is referred to as investment in working capital.
Definition of Working Capital
Working capital can be defined as: ‘Working capital is the money which a business has invested in its core operational activity mainly the inventory items which it sells, the receivables which it finances less the payables which are financing the company’.
Thus, by this definition, we understand that there are 3 core components of working capital. First is inventories, second is receivables and third is payables. Inventories and receivables add up to the investment in the working capital and the payables decrease the investment in the working capital. Thus, higher the payables amounts and days, the lower will be the working capital amount and days. Working capital is also referred to as Net Working Capital (NWC).
Formula for calculation of working capital
In order to calculate working capital amount of a business at any given time, we need to add receivables amount and inventory amounts subtracting creditor amount. This formula will give us the answer of working capital amount at any given date.
If we want to calculate average working capital of a business during a year then we need to take sum of average inventory and inventory receivables and subtracting average payables amount. This will provide us the answer of how much was the average working capital during the year for the business in amount.
Inventory + Receivables – Payables = Working Capital
The interesting thing about working capital formula is that it can be applied in two ways. One is that we can use all values in amounts and we’ll get the working capital answer in amounts ($ etc.). The other way is to use all values in number of days and then we will get the answer of working capital in number of days.
For example, if the inventory holding period is 15 days, receivables credit period is 30 days and payables credit period is 20 days, then the average working capital is 25 days.
Example of working capital cycle
Working capital cycle can be better understood in a business dealing in goods (as opposed to a business dealing in services). However, both types of business do have a working capital cycle and an amount invested in their working capital.
Let’s take example of a retail computer shop which purchases different laptops from wholesalers and then sale these units to individual customers. The Elegant Computers (Pvt.) Ltd, a fictitious name, purchases from laptops and then stores them in the shop for display to the customers. The money paid to purchase these inventories is investment on working capital.
Let’s say that at any one given date, the net position of the business is such that total inventories are $5,000, total receivables are $7,000 and total payables are $4,000. If we apply the formula of working capital calculation, adding receivables and inventory and subtracting payables, we’ll arrive at net investment figure of $1,200 for the business (i.e., $5,000 + $7,000 – $4,000).
Why we need to calculate Working Capital
Working capital management is a topic of ‘resource allocation’ or ‘budgeting’. Every company would need to understand its different classifications of expenditures. Studying each class of expenditures helps in correct analysis and allocation of resources. Some famous classifications of expenditures are capital expenditures (a.k.a CAPEX), operating expenditure (a.k.a OPEX) and working capital.
There are multiple reasons of calculating and analyzing working capital, as mentioned below:
- Working capital investment requires financing and this financing comes at a cost. We need to analyze our working capital to assess if we are maintaining an optimal level of inventories and receivables.
- Financing cost of working capital can be significant sometimes. We need to make decisions on how much credit period to be offered and what is the impact of this credit period on our financing cost and sales. We need to make right decision and therefore, we need to know our investment in working capital and the cost of this investment.
- Analysis of working capital can provide key insights into a business. For example, if the inventory number of days is unusually longer than the industry average number of days, then this might suggest some red flats (e.g., that we have either some obsolete inventory or our sales performance is lower than average.
- Management would be keen to negotiate best terms with suppliers and thus would need to understanding how much financing is coming from payables for working capital.
- It is important for us to understand how much money we need to invest and for how many days. Because, that money (working capital) will be blocked for that period. Similarly, we need to know, how much money will be received and after how many days.
Calculation of Debtors Days, Creditors Days and Inventory Days
In order to calculate working capital in days, we need to add inventory days and receivables days and subtract payables days. The formulas for the inventory days, receivables days and payables days are given below.
In order to calculate average inventory, we can add opening and closing inventory in a year and then divide it by two. Alternatively, we can use closing inventory figure if average inventory figure is not available.
Receivables days can be calculated by dividing average receivables with annual sales. Average receivables are calculated by adding opening receivables figures and closing receivables figure and then dividing it by two.
Payables day can be calculated by dividing average payables in a year with cost of sales. Average payables are calculated by taking average of opening and closing payables for the year. If average payables figure is not available, then closing payables figure can be used in the formula of payables days.
Here we have used 365 days in the formula but in practice, some companies may use 360 days (keeping fix 30 days for 12 months).