Appraisal of Working Capital

Measures of Working Capital

• Measures of performance: Assess a company's financial performance and profitability, including profit margins, Return on Capital Employed (ROCE), asset turnover, and Return on Assets (ROA).
• Measures of working capital: Evaluate the effectiveness of a company's management of working capital elements.
• Measures of solvency and liquidity: Determine a company's ability to meet its liabilities as they become due.
• Measures of return on investment and risk: Gauge a company's capacity to generate returns for shareholders and the associated level of risk.

Outline

• What is Working Capital?
• Working capital ratios in times
  • Receivables turnover
  • Payables turnover
  • Inventory turnover
• Working capital ratios in days
  • Settlement period for receivables
  • Payment period for payables
  • Inventory holding period
  • Operating cash cycle

What is Working Capital?

• Working capital is the net current assets, calculated as current assets minus current liabilities.
  • $Working Capital = Current Assets - Current Liabilities$
• It indicates the financial resources available for daily operational needs.

Components of Working Capital

• Current assets: Include cash, inventory, accounts receivable, and short-term investments.
• Current liabilities: Include accounts payables, short-term debt, and accrued expenses.

The Working Capital Cycle

The working capital cycle involves:

1. Raw Materials
2. Work in Progress
3. Finished Goods
4. Cash Sales
5. Credit Sales leading to Trade Receivables, which eventually convert to Cash in Bank/Hand.
6. Trade Payables

Working Capital and Short-Term Financing

• Working capital occupies cash.
• Poor working capital management leads to higher working capital needs, requiring more cash and short-term financing, which in turn causes pressure on the company’s liquidity.
• The less working capital a company needs, the less pressure on cash, reducing the need for short-term financing.
• The size and composition of working capital differ across industries.
  • Service industry (e.g., consulting):
    • Low/no inventories, mostly receivables/payables.
    • Short business cycles result in low working capital needs.
  • Manufacturing industry:
    • High inventories (raw materials, Work in Progress (WIP), finished goods), high receivables/payables.
    • Long production cycles result in high working capital needs.

The Family of Working Capital Ratios

• Three components:
  • Trade receivables: More trade receivables mean less cash at hand.
  • Inventories: More inventories mean less cash at hand.
  • Trade payables: More trade payables mean more cash at hand.
• Working capital ratios are expressed in two forms:
  • In periods (number of days).
  • In times.

Days and Times Relationship

• Days and times are inverses of each other, representing the same meaning in different formats.
  • If something happens once a year: $x1/year \rightarrow 365/1 \rightarrow 365 days$
  • Twice a year: $x2/year \rightarrow 365/2 \rightarrow 182 days$
  • Three times a year: $x3/year \rightarrow 365/3 \rightarrow 122 days$

Account/Trade Receivables

• Accounts Receivable (A/R) Turnover
  • $A/R Turnover = \frac{Credit Sales}{A/R}$
  • $Days A/R Outstanding = \frac{365 days}{A/R Turnover}$
• A/R Turnover: Measures how many times accounts receivable