A Comprehensive Look At Working Capital Management


Working capital management is a very important part of a company’s operations. It is something to have a very strong understanding of because it feeds in to the definition of a firm’s value from operations, which ultimately decides the “fair market value” per share of the company’s stock.

On it’s way to maximizing firm value, a company will adopt various working capital policies to suit its needs over time. This tutorial covers the particulars of what those policies are including the relevant ratios and definitions.

Let’s begin by asking, how does working capital feed in to the definition of a firm’s value?

To understand where working capital fits it, let’s first define what determines a firm’s value from operations. The value of a firm is defined by the present value of expected future free cash flows. The formula for this definition of value is:

Working Capital - Value from Operations Definition

Value From Operations Formula

Free Cash Flow is the cash that is available to those who have a claim with the company through investments (shareholders) and through debt (lenders). In order to derive Free Cash Flow, the income statement and balance sheet are needed. The first step to FCF is to figure out Net Operating Profit After Taxes (NOPAT). This can be done with the income statement. Below is what you will need to figure out NOPAT.

Deriving Net Profit After Taxes (NOPAT) 
Total Revenues   ——— All sales and revenues generated by the company
   - COGS   ——— Cost of Goods Sold
Gross Profit   ——— Indicates profit available to pay for operating expenses
   - OPEX   ——— Operating Costs including non-cash items like Depreciation & Amortization *
EBIT   ——— Earnings Before Interest Expense and Tax Expense
   - Tax Provision   ——— Includes Federal and State Taxes
NOPAT   ——— Net Operating Profit After Taxes

* Note that Interest Expense is not taken out. The reason is because Interest Expense falls under the definition of Free Cash Flow – Interest is a claim by lenders, so FCF will need to include interest expense.

Once NOPAT has been figured out, adjustments are made to this number to come to the FCF value. This is where Working Capital comes in to play.

Deriving Free Cash Flow 
NOPAT   ——— Net Operating Profit After Taxes (See Above)
  – CAPEX   ——— Capital Expenditures by the company to support growth of operations (It’s a use of Cash)
  + D & A   ——— Add back Depreciation & Amortization since they are not cash based expenses
  - Δ in Working Capital   ——— Change in working capital** from prior period (Can either be a source or use of cash)
Free Cash Flow   ——— Cash that is available for distribution to lenders and creditors

** Working capital from an accounting perspective equals Current AssetsCurrent Liabilities. This is not the definition one should use for Free Cash Flow purposes. Finance’s definition of working capital, also known as net operating working capital (NOWC) is a modification of the accounting definition.

Net Operating Working Capital

Finance’s definition = Current Assets (Less interest generating assets, or more specifically, Marketable Securities) – Current Liabilities (Less interest bearing liabilities, or more specifically, short term debt). In some circles, cash is also excluded from Current Assets, under the assumption that cash will be used for certain unexpected business transactions. If a company has requirements to keep compensating balances as part of an agreement with its lenders, that’d also be a good reason to exclude cash since there is restricted usage.

Deriving Net Operating Working Capital
Current Assets   ——— Begin with everything in current assets (i.e., A/R, Inventory, Prepaid Exp., etc.)
  - Cash* & Marketable Securities   ——— Exclude all or part of cash based on your analysis of cash position
  – Current Liabilities   ——— Exclude everything first
  + Short Term Debt   ——— Add back short term debt (i.e., Notes Payable) since it’s interest bearing debt
Working Capital (NOWC)   ——— Use this figure for determining Δ in Working Capital

Note that the Free Cash Flow formula calls for change in working capital. At this point, the current period’s NOWC will need to be compared with the prior period’s Net Operating Working Capital to see what the change is. If there is an increase in working capital investment by the company, that will reduce free cash flow. On the contrary, if there is a decrease in working capital investment period to period, there will be an addition to free cash flow. See example below:

 Change in Working Capital with Impact on Free Cash Flow
  FY 201X FY 201Y FY 201Z
Current Assets 3,534 4,905 3,114
 - Cash & Marketable Securities 1,415 2,411 1,510
 - Current Liabilities 1,352 1,333 1,345
 + Short Term Debt 15 17 20
Working Capital 782 1,178 279
Δ in Working Capital - N/A – Starting Pt. + 396 from 201X -899 from 201Y
Notes   Reduces FCF Increases FCF

One last piece of the formula for defining a company’s value that you should be familiar with is Weighted Average Cost of Capital. WACC, sometimes referred to as the “discount rate” or “hurdle rate” is used to discount future cash flows to take the time value of money into consideration. WACC is essentially a weighted average of the cost of debt and the cost of equity. In other words, WACC reflects the interest rate the company pays for borrowing and the rate of return investors in the company expect on the money they have invested. The formula for WACC is: W(1-T)r+ We rs

Wd  - stands for the percentage of the company’s financing through debt. So if a company has $100 in debt and $200 in equity, the percentage of the firm’s financing through debt would be = $100 / ($100 + $200) = 1/3 or 33%

*(1-T) - T stands for the corporate federal and state tax rate. Interest expense is tax deductible, so this part of the formula takes care of that

*r- represents the interest rate charged by lenders on the money borrowed by the company

*W- the percentage of the company’s financing through equity. If a company has $100 in debt and $200 in equity, the percentage of the firm’s financing through equity (investors) would be = $200 / ($100 + $200) = 2/3 or 67%

*rs - expected rate of return by investors

Now that you understand the how, where and why of Working Capital, it’s time to look at how it’s evaluated and managed by companies.

Evaluation and Management of Working Capital:

By referring to a select number of financial metrics, it is easy to come to a conclusion about a company’s working capital policies and how each aspect of working capital is managed. These are the ratios / metrics that are related to working capital policies:

Working Capital Related Ratios
Ratio Formula
Current Ratio Current Assets / Current Liabilities
Quick Ratio / Acid Test Ratio Current Assets – Inventory / Current Liabilities
Cash Ratio Cash + Marketable Securities / Current Liabilities
Cash Turnover Ratio Revenues / (Cash + Marketable Securities)
Inventory Turnover Ratio Revenues / Inventory

To learn more about how to interpret these ratios, read Key Financial Ratios – Liquidity. Generally speaking, the higher the Current and Acid Test ratios are, the better. A comparison between the firm you are evaluating and industry averages should give you a better idea of how working capital fares for that company.

Upon examining the turnover ratios, you’d get an idea of the type of policies in place for that company. Essentially, the firm can employ 3 different types of Working Capital policies. They are:

* A Restricted / Conservative Policy – whereby the firm limits its holding of current asset items like Cash, Marketable Securities and Inventory. Current Asset turnover ratios will be high in this case. While this might seem like a great policy to adopt, it may not always be suitable. A conservative policy dictates tight credit policies which results in limited sales.

* A Relaxed / Liberal Policy – the firm carries a lot of Cash, Marketable Securities and Inventory. Turnover ratios will be low in this case and will result in more receivables due to more sales and a loose credit policy. The risks associated with having a loose credit policy toward customers is non-payment (Bad Debt) or late payments, which also carries a cost.

* A Moderate Policy – one that is somewhere in between that tries to strike a balance.

Working Capital – A brief look at Credit Policy:

There are a handful of elements that go into the credit policy of a firm. Credit policy not only impacts finances, but also customer relationship management. In some instances, credit policy alone can impact a company’s ability to generate a profit.

Credit Policy Summary
Policy Element Notes
Discounts An incentive provided to customers in order to generate additional sales
Credit Terms The time allotted by a firm to it’s customers for payment. Extending the Grace Period will increase Days Sales Outstanding and Accounts Receivable. It does, however, encourage more sales to take place. Reducing the grace period has the opposite effect. The interest rate charged for financing purchases also plays an important role.
Collections With a liberal working capital policy, outstanding debt will be higher. How aggressively, or not so aggressively the company goes after late payers will impact customer relationships
Standards by Which Credit is Extended Loose credit standards (i.e., extending credit to someone with a bad credit history) will increase sales, but will also increase accounts that default on payment and go in to collections. A good portion of these accounts will never pay, which will increase bad debt and reserves.

To determine how working capital is managed on a day to day basis by a firm, there are certain measures that can be utilized to provide you with specific information. They are:

Working Capital Management Measures
Measure Formula Notes
Days Sales Outstanding Accounts Receivable / (Revenues/365) The length of time it takes the firm to collect money from customers following a purchase.
Inventory Conversion Period Inventory / (Revenues/365) The time it takes to convert raw materials into finished goods and sell those goods to customers
Payables Deferral Period Payables / (COGS/365) The time it takes the company to pay for things purchased on credit. This can include raw materials, finished goods or even services for certain companies
Cash Conversion Cycle Days Sales Outstanding + Inventory Conversion – Payables Deferral Measures the gap between paying for business expenses and receiving payment for sales or services

As you can see, the most comprehensive working capital management measure is Cash Conversion Cycle, which includes the other three measures outlined above. Optimizing the cash conversion cycle does not always mean that it should be a short period. Things have to be balanced so as to not negatively increase the need for additional borrowing (as it would be the case with a long period). Attempting to shorten the cash conversion cycle too much can also negatively impact sales and business relationships.

In the event a company has the flexibility to reduce the Cash Conversion Cycle, a few tactics can be employed to make that happen. By speeding up collections of Accounts Receivable, Days Sales Outstanding can be reduced. Similarly, accelerating the time it takes to go from raw materials to an actual sale will also reduce the cash conversion cycle. Last but not least, a company can wait to pay it’s suppliers (without going overboard) in order to reduce this measure. A combination of any of these tactics will result in the best optimization for the companies that can effectively do it.

Financing Working Capital:

Another aspect to working capital management is the financing. Financing working capital can takes a few forms so knowing what they are and the costs associated with them will enable a company to take advantage of certain opportunities.


When it comes to financing working capital, there is only one form that is completely free from interest charges – and that would be Accruals. Current Liabilities items like accrued salaries and taxes are a source of cash until they have to be paid. This may not seem significant, but it can make a difference for small organizations. The only drawback is that a firm can’t really exercise much control with its level of accruals.

Accounts Payable:

These are liabilities based on Trade Credit. As discussed earlier, deferring payables can be source of cash. However, Trade Credit has its costs. Very often, vendors will extend specific terms with their invoices. Sometimes those terms include incentives to pay early. Foregoing those incentives can be very costly.

For example, if a vendor issued an invoice with the terms 2/10 net 30, it means the company can take a 2% discount from the invoice if they pay within 10 days. If they don’t pay within the 10 days,  the full value of the invoice is due within 30 days. 2% may not seem like a lot, but when you take the time value of money into consideration, the cost of foregoing the discount can be astronomical.

Short Term Debt & Lines of Credit:

A firm can elect to borrow cash from banks to finance working capital or work with a line of credit. There are, of course, interest charges associated with borrowing short term and those rates can be unpredictable. Time frame to repay those loans occur much quicker than long term debt so it’s riskier to borrow short term if the business is small or is struggling. In the event repayment is not possible, a company may have to face bankruptcy or other costly penalties.

Working Capital Financing Through Commercial Paper:

Usually done by large organizations in good financial health. A company that meets this criteria can offer commercial paper out in the market. Commercial paper is a short term unsecured note that promises principal + interest. The interest rates are usually a little better than those of treasury bills.

Working Capital Financing Policies

Current Assets (Net Operating Working Capital) are classified as either Temporary (seasonal) or Permanent, meaning these assets are always there and core to the business. Inventory for example is a Permanent asset.

As it was the case discussed above with general Working Capital policies, financing policies pertaining to Working Capital can also be 3 tiered. Some companies may elect to take care of their working capital needs along with the issuance of long-term debt, so short term debt would essentially be zero. This would be the conservative approach. Any temporary excess cash that a company may have from issuing long-term debt will most likely be invested on a short term basis.

On the other hand, issuing short-term debt seasonally as working capital needs change (with Temporary Current Assets) would indicate a moderate approach towards working capital financing. And finally, an aggressive working capital financing policy indicates that a company is using short-term debt to finance all of the temporary and a portion of the permanent assets.

One Response to A Comprehensive Look At Working Capital Management

  1. Kaylene G says:


    can you provide some examples of temporary current assets?


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