~Situation Analysis~

 Company Situation: Financials

Working Capital = Current Assets - Current Liabilities

Why should you be keenly concerned with Working Capital? Let's take a closer look at the dynamics.

One needs to make a distinction between "The Company" and "The People That Have a Claim on the Company". The Balance Sheet makes this clear.-This is why a Balance Sheet always balances. The left is "what is owned", the right is "who owns it".

 Assets are split into two categories, Fixed and Current.

At a deep level, the Fixed Assets create wealth.

The Current Assets could be characterized as "a cost of doing business" or worse as "a necessary evil". In a perfect world, you would have $1 of Cash, $1 of Accounts Receivable, and $1 of Inventory. Indeed, these are often goals for just-in-time initiatives. Cash creates insignificant wealth (and in Capstone^® you do not even earn interest). Accounts Receivable is a loan given to customers. Unsold Inventory consumes resources and costs money to carry.

In the example above, $31 million is locked in Current Assets. If you could put that money to work at, say, 10%, you would earn $3.1 million.

Why give that up? The argument for Accounts Receivable terms (say 30 days) is that it increases demand, and at some point the profits from the increased demand are greater than the cost of the money we are lending to customers.     However, if every competitor offers 30 days, you get no additional gain in demand, yet bear the cost of the loans you give customers. You only see increased demand if there is a spread between your policy and competitors. Typically, you cannot reduce your policy because you would see a decrease in demand.

Inventory and Cash must be considered together. You can think of inventory as crystallized Cash. If you sell the Inventory, it is converted back to Cash. If demand is below expectations, Cash is converted to Inventory. Since you cannot predict what competitors will do, you cannot predict demand perfectly.  Therefore, your Cash plus Inventory position is a hedge against two risks — the risk of stocking out, and the risk of building too much inventory.

The $31 million in Current Assets came out of somebody's pocket.

?=how much was funded from equity (common stock and retained earnings), and how much from the two relevant debt holders, bankers (current debt) and vendors (accounts payable).
<Equity holders and debt holders have competing interests> Equity holders would prefer to fund Current Assets with debt, or reduce Current Assets. Debt holders worry that if they fund too much of the Current Assets, the company might default during difficult times.  

 Debt holders monitor the situation with the Current Ratio:

Where Working Capital looks at the issue from the Equity holder's perspective (how much of my Equity is in use), the Current Ratio is looking at the issue from the Debt holder's perspective.

(Current Ratio = Current Assets / Current Liabilities)

• A Current Ratio of 1.0 means Current Assets are entirely funded with Current Liabilities. Bankers and vendors hate to see your Current Ratio at 1.0 because if anything goes wrong, you cannot pay your bills, and this puts them in the awkward position of either giving you more money or letting you go bankrupt. As the Current Ratio rises towards 2.0 they become less worried.

• If the Current Ratio is 2.0, for every $2 of Current Assets, you have $1 of Current Liabilities and therefore $1 of Equity invested.

• If the Current Ratio s 3.0, then for every $3 of Current Assets there is only $1 from Debt holders. The bigger the number, the less the risk faced by Debt holders.

Now let's examine reducing Current Assets. Consider these cases:

Case 1 and 2 both have Current Ratios of 2.0, but Case 2 is much more worrisome. If demand increases, you stock out after selling only $2.5 million of inventory. If demand falls, you run out of cash after building only $2.5 million of additional inventory. You have little room for error.

To a degree, this issue is exposed in the Working Capital magnitude. Case 1 features Working Capital of $10 million; Case 2 only $6 million. Yet this ignores the question of how much Working Capital you really need. That is driven by sales volume over time. For a small company, $6 million might be adequate and $10 million too much. For a large company, $10 million might be too little.        
    This issue is addressed in "Days of Working Capital", defined as Working Capital / (Sales/365), or more simply, the number of days we could operate before our Working Capital would be consumed. You get 50 points if your Days of Working Capital falls between 30 days and 90 days.

In the example above, where sales are $100 million per year, Case 1 features 36.5 Days of Working Capital. That is a bit on the thin side, but within acceptable limits. Case 2 is too thin at 21.9 Days of Working Capital.

Case 3 is a variation on Case 1. It illustrates what can happen when you start with thin reserves. There are 38.3 Days of Working Capital, and the Current Ratio is 2.0. Things look okay, but notice that you have no Cash. Our sales forecast was too optimistic. Inventory accumulated beyond our worst case, consuming all of our Cash. We were forced to take an Emergency Loan from Big Al. While one could argue that the problem here was forecasting, we were forecasting in an environment where we were tight for Working Capital. A small error resulted in disaster.

To summarize, your Working Capital position is the consequence of a set of policy decisions.

1. What is the minimum Current Assets we require?
2. What is the maximum Current Assets we will accept?
3. How will we fund Current Assets, with debt or equity?

The equity portion is your Working Capital. These policy decisions can be evaluated with the Current Ratio and Days of Working Capital.