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Working Capital

Working capital = Current Assets – Current Liabilities

Asset:

Asset is a resource held to produce some economic benefit. Cash, Inventory, Accounts receivable and property are all examples of an asset.

Current Assets:

An asset whose economic benefit is expected to come within a year is called a current asset. Cash, inventory and accounts receivable are an example.

Liability:

A liability is any debt or a financial obligation of a company. Accounts payable, accrued expenses, long term debt or a deferred tax liability are examples of liabilities.

Current Liability:

A current liability is a debt or a financial obligation of a company that is due within one year. Accounts payable or accrued liability are examples of a current liability.

If working capital is a positive number, current assets are greater than current liabilities, we will potentially have more than enough funds to cover our liabilities.

If the working capital is negative, currents assets are less than the current liabilities, we do not have enough resources to pay our current liabilities.

Operating Working Capital:

Operating working capital is defined as current assets less current liabilities. We do not include cash or cash equivalents as part of current assets and we do not include debts as part of our current liabilities.

Cash Equivalents:

Assets that can readily converted into cash are called cash equivalents. Money market holdings, short term government bonds, treasury bills, marketable securities and commercial paper are all examples of cash equivalents.

If we remove cash equivalents we are left with accounts receivable, inventory and prepaid expenses.

If we remove debts, we are left with accounts payable and accrued expenses.

Operating working capital helps track how well a company is managing its cash generation from day to day activities.

As an example, if accounts receivable is increasing year over year it could mean that company is facing collection problems. It can also mean that accounts receivable is growing because company’s revenue is growing. This could be a good indicator of strong business growth. A measure of days to track how well are we collecting our receivables or paying our bills can give us a good comparison.

Days are measured by dividing the receivables or payable by its related income statement item and multiplying by 360.

Example:

Let us say a company had a revenue of 100,000 and balance accounts receivable = 25,000 in 2012.

Income Statement:

Revenue = 100,000

COGS = 10,000

Operating Expenses = 85,000

EBITDA = 5,000

Operating Working Capital:

Accounts receivable = 25,000

Inventory = 7,500

Prepaid Expenses = 1,000

Accounts payable = 12,500

Accrued expenses = 15,000

Net working capital = 6,000

Percentage of accounts receivable = 25,000 / 100,000 = 25%

Multiplying this number with the number of days in a year = 25% x 360 = 90

So on average 90 days are outstanding is a year. As a rule of thumb, many companies require customer receipts to be paid within 30 days. So 90 days could be considered on higher side. It can be considered okay depending on the business model and product sold.

Use of 360 days instead of 365 days makes modeling simpler.

Formula for Accounts receivable days:

Accounts receivable days = Accounts receivable / Revenue x 360

Let us now take an example of using a liability. Let us say accrued expense balance in 2012 = 15,000. The 2012 operating expenses = 85,000. The accrued expenses 15,000 equals 17.6% of the total expenses. Which means 17.6% of our expenses are not paid in 2012. We multiply this percentage by the number of days in one year to get an equivalent number representing how many days these payables have been left outstanding.

17.6% x 360 = 63.4

So of the 2012 expenses, 63.4 days are still outstanding which can be considered as too high in this case. On average accounts payable should be paid every 30 days.

Accrued expense days = Accrued expense / Operating Expense x 360

Disclaimer:

This information is for educational purposes only. It does not constitute any legal advice or opinion. Please do not use any of its contents without seeking a professional advice.

References:

Financial modeling and valuation by Paul Pignataro

Mansoor Suhail (Mani)

Accountant

BSBA – EA – ICIA – RA

Tax for Canada and U.S.A

Web: www.theaccountingandtax.com and www.taxservicesguru.com

Blog: http://taxservicesguru.blogspot.ca

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