Working Capital is the cash needed for a business to carry on operating and covering short-term obligations. Understanding a business’s Working Capital needs is a great way to measure the near-term liquidity and risk factors of a business to carry on day-to-day activities. It can provide investors insights into the operating efficiency of the business as well as aid financial modelling and valuation.

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What is Working Capital?

Working Capital is an often misunderstood and underutilised area of analysis for many investors. It can be challenging to decipher depending on the business model and complexity of its operations. To truly value a business and understand the opportunity, or risk, investors need to understand a business’s capital needs to operate, the working capital cycle and the efficiency with which a company turns capital and assets into revenue and then profit.

The money a company needs to run day-to-day activities is called working capital. Think about working capital from a personal perspective and running your household. You get paid a salary which is your revenue. There are short-term obligations whether it is rent, a mortgage, groceries, fuel for your car, insurance, utilities, or a billion streaming services.

Now imagine half of the costs to run your household fell due before you got paid, and the other half after you got paid. You would need to manage your cash flow quite efficiently to ensure you met all the short-term obligations to run your home. Now you may have some savings on hand to ensure if you were paid late, you were able to keep paying the bills. Picture not getting paid your salary for one month, this “Working Capital” would require you to dip into your savings to cover the expenses. If this savings runs out your “Working Capital” is going to be squeezed causing you to maybe miss some bills.

Whilst this is an oversimplified example, this is the same challenge a business faces with the added layer of inventory. The balance between getting paid on time, and meeting all short-term obligations such as paying staff, suppliers, rent and financial commitments. A company may dip into its cash reserves to be able to pay the bills.

Why is knowing Working Capital important?

Working Capital is about understanding a business’s overall health and efficiency to manage its day-to-day affairs. By understanding a company’s working capital needs and cycle, we can determine how efficient it is at turning its current assets (inventory) into profits and cash. This can give investors insights into the speed at which a business gets a return on its investments.

I believe understanding the working capital layout of a company gives investors a precious look inside the business model and its near-term liquidity, operating efficiency, and short-term financial health. If an investor can truly understand a business’s capital cycle and demands, it means they’ve put the work into researching how the business functions. This is what true investing is about, investing in operating businesses and not a ticker price on a computer.

Working capital is like your diet; if you do not manage it, then it can kill you.

Dan Corredor

By understanding the working capital of a business, investors will be better equipped to know the risks a company may face over the short term. It can also help investors stay put during short-term hiccups that all businesses face at some stage. When it comes to valuation, it is helpful when conducting a Discounted Cash Flow model and projecting business financials. Working Capital majorly impacts a company’s cash flow.

Opportunities and Risks can be discovered when analysing this area of a business. A business may thrive over competitors by having a more robust system that ensures day-to-day activities operate seamlessly. On the other hand, risks can come from a company that poorly manages its working capital needs and cycle, always putting it behind the 8 ball.

Understanding the business model first.

Before diving into any working capital calculations, it is best to understand the business model and grasp the basics. If a company relies on inventory i.e. raw products and goods that are stored or require manufacturing, it becomes even more important. There will be very different outcomes when comparing business models across various industries.

Think about a SaaS or IT business with a low capital-intensive operation as opposed to a furniture retailer, that requires outlaying for inventory, storing it and then trying to convert it to cash.

The first step is in trying to determine what is core business activity. Think like a business owner. Think about paying and receiving cash. This will help us to determine what is essential to day-to-day operations. Working Capital calculations will focus on three areas, and once they are understood you can start piecing the operations together.

I like to focus more on trades payable and receivables for a business that relies heavily on inventory. TRADES relates directly to the payments to vendors and suppliers and the money customers owe on credit. This can give investors a better look at core operational needs.

It’s best to ask, “What does the business need to do over the next 12 months to keep functioning and growing?” in combination with:

• Does the business get paid upfront for products and services?
• Are the vendors or suppliers paid upfront or do they extend credit terms?
• If customers received products and services on credit what are the payment terms?
• How long does inventory take to arrive from order to becoming a COGS?
• What are core operational expenses each month for the business?

They may be basic areas to look at but will provide critical details about the cash inflows and outflows of the business.

How to Calculate Working Capital?

Now that we’ve covered the basics, let’s delve into the calculation of working capital and explore other key metrics. Working capital can be categorised into three parts, each playing a role in understanding the efficiency and value of the business. They are Net Working Capital, Working Capital Cycle and the Working Capital Turnover.

The key formula calculates NWC (Net Working Capital). NWC represents the variance between the incoming funds and the short-term obligations of the business. This can result in either a negative or positive NWC, which we will discuss later.

Three simple formulas can be utilised, ranging from basic to slightly more detailed. Each formula has its purpose and is chosen based on the business model and whether the company relies on inventory to generate revenue.

Simple NWC formula:

NWC = Current Assets – Current Liabilities

Detailed NWC formula:

NWC = Current Operating Assets – Current Operating Liabilities

Comprehensive NWC formula:

NWC = Accounts Receivables + Inventory – Accounts Payable

The simple formula is suitable for businesses with minimal cash or debt, providing fairly accurate results. The slightly more detailed formula eliminates the impact of cash and debt, particularly if they constitute a significant portion of the current assets and liabilities. Cash and debt are non-operational and don’t impact revenue.

The more comprehensive formula focuses solely on incoming cash, inventory (an asset that can be converted to cash through sales) as well as the company’s outstanding obligations.

*As a simple example below is Net Working Capital of the same small-cap company we have been using throughout the Financial Statements section.

Once again, the formula will vary depending on the nature of the business. If a company has substantial inventory and numerous vendors, the more intricate formula will offer a clearer depiction of working capital.

Components that make up Working Capital.

When looking at Net Working Capital it is not as simple as current assets and current liabilities. Investors need to understand what falls under these categories that can impact working capital. Here is a list of all the components that can help understand what goes into a business producing its goods and services.

Current Assets	Current Liabilities
WIP (Works in Progress)	Vendors and suppliers
Raw Materials (Not converted to inventory)	Short Term creditors
Finished Goods	Short Term borrowings (interest)
Inventory on hand	Proposed dividends (outflow)
Advances – Prepaid works	Unearned Revenue
Cash	Accrued Liabilities
Marketable Securities	Lease obligations
Accounts Receivable	Accounts Payable

The Working Capital Ratio.

The working capital ratio is an important metric that indicates the company’s short-term financial health. This ratio assesses whether a company has the right operating efficiency and liquidity to meet short-term obligations. In simple terms, within the next 12 months can this company pay its bills, loans, staff, and expenses to keep the show running.

The formula is simple:

Working Capital Ratio = Current Assets ÷ Current Liabilities

As a guide, a Working Capital Ratio of less than 1 means a company may struggle to cover its short-term obligations. A number between 1 and 2 is a good indicator that a business has sufficient needs to keep operating. A number over 2 may reflect a company holding too much cash, this is when a more comprehensive look at NWC can shine a better light on the operations.

All businesses should try to maintain the right working capital ratio. Too low, the company may face operational challenges and too high may mean the company is not maximising excess funds. Management pays attention to this ratio to help understand the internal capital needs as well as guide any strategies to improve NWC.

If we use our small-cap example above and calculate the Working Capital Ratio it would simply be:

Current Assets $25.7 ÷ Current Liabilities $9.2 = 2.79.

This indicates the business is holding a lot of cash (which it does) and has minimal debt. For a small-cap business that needs cash to continually fund operations it is not a bad position to be in. It beats a lot of small-cap companies with a ratio of 0.1.

Changes in NWC (Net Working Capital).

Once you’ve worked out the net working capital for a business another key step is to determine the changes in NWC over a specific period. “Changes in NWC” calculates the differences between current operating assets and operating liabilities over the selected period.

This measurement can help to understand the working capital needs of a business and how it is evolving year-to-year. The change will either represent a decrease in NWC or an Increase in NWC. A negative change does not necessarily indicate a bad business, nor does a positive change reflect a better operation. These changes are impacted by a variety of reasons all around how the company conducts its day-to-day activities.

The formula to determine the Change in Net Working Capital is simple. Select the period being measured, for example, we want to compare this current financial year to last year’s financial year to get insights into working capital.

Change in NWC =

Working Capital (Current Period) – Working Capital (Previous Period)

Or we can measure the change in Current Operating Assets – Current Operating Liabilities. To do this we find the difference between current operating assets and current liabilities last year. Do the same for the current period and subtract the yearly NWC differences.

Let’s use the small-cap example once more and look to the balance sheet to work out the changes in NWC.

2022 NWC: If we start with the 2022 financial year and add up Operating Assets, we get $15.2m. If we deduct the operating liabilities of $4.2m we get a NWC of $11m.

2023 NWC: Operating Assets of $16.7m and deduct operating liabilities of $4.6m we get an NWC of $12.1m.

Change in NWC: To find the changes we deduct 2023 NWC $12.1m from 2022 NWC $11m to get a change in NWC of $1.1m.

Changes to NWC in the Annual Report.

The beauty is companies list the changes in working capital from year to year in the Annual Report. In the US, changes (Increase or Decrease) in working capital will be shown on the cash flow statement and are already connected. In other parts of the world, Notes to Financial statements and a “Reconciliation of Cash Flow” will show the changes in working capital. It looks like the below example from our small-cap company.

The statement will clearly show the line item for changes in Working Capital. It will be laid out like the above example, where we must add the line items. Or the heavy lifting will be done for us, and it will be presented as follows:

Decreases / (Increases) in Working Capital Assets:

Increases / (Decreases) in Working Capital Liabilities:

The decrease or increase reflects the flow of cash. Investors can then manually take the changes to work out how it is evolving over the years.

It’s best to take guidance from exactly what the company lists as working capital. The statements will clearly reflect the increases or decreases around receivables, inventory and payables. This makes it easy when focusing on Operating Assets and Liabilities.

What does the change in NWC tell us?

The changes in Net Working Capital (NWC) have a significant impact on Free Cash Flow. If a company increases its net working capital over time, it indicates that current operating assets have grown or current liabilities have decreased, or both. Understanding a company’s working capital and its changes allows us to comprehend how much Free Cash Flow is likely to diverge from Net Income over time.

⬆️ Increase in NWC = Less Free Cash Flow

⬇️ Decrease in NWC = More Free Cash Flow

The key to understanding working capital changes lies in how the cash inflows and outflows change. This aspect can be unclear when modeling cash flow over time.

➖ When NWC increases, the change will be negative as it represents a cash outflow.

➕ When NWC decreases, the change will be positive as it represents a cash inflow.

These movements shed light on the business model and its cash inflows and outflows. A positive net working capital indicates that the business collects cash up front (bills in advance) as customers usually pay for a service prior to receiving the products and goods.

A negative net working capital may indicate that the business outlays cash, such as purchasing inventory, paying suppliers, vendors before receiving cash from customers, or customers paying on credit. This means the company will be spending money upfront before generating revenue from sales.

For example, an accounting software business may have subscribers who pay a year upfront for the service, while a furniture retailer has to buy and showcase furniture before receiving payment from customers.

The difference between Positive & Negative Working Capital.

The changes have a significant impact on operations and the financial health of a business. A positive change in NWC means the company will be in a better cash position as money comes in before it goes out. On the other hand, a negative change means the business must ensure it has cash on hand to finance operations as it is outlaying before it can turn a profit.

However, without context of the business model, both positive and negative are neither good nor bad. While a positive NWC can be good as it reflects operating assets being more than operating liabilities, too much can also be a sign of a build-up in inventory. A negative NWC may reveal a business can face challenges meeting short-term obligations. However, if we dig beneath the surface, it may reveal a healthy business that just has a timing issue from when it pays out and collects revenue. There are many healthy companies in both camps, don’t be bias.

Liquidity is key here. Increases in NWC are great if the business has cash on hand to keep funding operations; otherwise, it may not be able to fund operational activities.

A basic way to look at this is if both operational assets and liabilities have increased in tandem, then there will be no change. When the current liabilities increase faster or more than the current assets, this causes a positive change in NWC. Vice versa, when current assets grow more than current liabilities, this causes a negative change in NWC.

This simply means the negative change indicates a business model that spends money before cash comes in and sales growth. If the change is positive, then the business is earning cash upfront as the revenue grows.

🔁 Working Capital Cycle.

The “Cash Conversion Cycle” (CCC) is a financial efficiency metric related to working capital. It measures how quickly and efficiently a business turns its investments in inventory and other assets into revenue and then into cash. Essentially, it indicates how long it takes for the business to get its cash back after deploying it.

The CCC focuses on inventory management, outgoing payments to suppliers (creditors), works in progress, and cash collection. The duration between using cash to purchase inventory, deploying it, and collecting cash from customers is crucial for investors to understand. This process involves a time lapse between each stage.

A long cash conversion cycle means the business needs a lot of working capital to fund day-to-day operations while waiting for revenue and customer payments. This ties up cash for longer. Conversely, if a company receives customer payments before settling with vendors, the cycle shortens. A shorter cycle improves cash inflows, increases working capital, and allows the business to operate more efficiently.

The way a company handles each stage can impact the working capital cycle. For example, implementing a better collection system to ensure timely customer payments or improving inventory management and turnaround times. Another approach is to pay vendors slowly, allowing customers to pay first to enhance cash inflows.

Understanding the working capital cycle can help investors comprehend the trajectory of business operations over time. It is essential for understanding a company’s liquidity and how changes in Net Working Capital (NWC) will affect free cash flow, providing insights into the cash tied up in working capital.

Cash Conversion Cycle Formula.

The formula for calculating the working capital cycle involves three key components. Each component provides insight into the timing of a business’s incoming and outgoing cash flows. The calculation to work out the working capital cycle is:

Working Capital Cycle =

Days Inventory Outstanding + Days Sales Outstanding – Days Payable Outstanding

To illustrate how the stages break down, consider the following example:

Payable Days: A business buys inventory on credit and has 60 days to settle the bill.
Inventory Days: The business sells this inventory within 45 days.
Receivable Days: Customers pay the business for received goods in 25 days.

Using the formula: 45 + 25 – 60 = 10, we find that the company is, on average, out of pocket for 10 days in its working capital cycle. So the operating cycle shows the time between when cash was invested and when the cash came back to the business.

➕ A positive cycle means the company is out of pocket by that many days.

Now, let’s imagine a company that has 90 days to pay suppliers for inventory, takes 30 days to turn inventory into sales, and receives payment from customers within 30 days.

Using the formula: 30 + 30 – 90 = -30, we find that the company, from a cash flow perspective, is ahead by 30 days, as it still has 30 days to pay suppliers after deploying the inventory and receiving payment for it.

➖ A negative cycle means the company is ahead by that many days.

Overall, a shorter cycle is ideal. This allows the business to free up the necessary cash without having capital tied up in operations. If a company has a longer cycle it is more dependent on cash reserves or financing to fill the time gap between cash outflows and inflows.

(DPO) Days Payable Outstanding.

The DPO ratio measures the average number of days for a business to pay its bills. The formula to measure days payable outstanding is.

(Accounts Payable ÷ Cost of Goods Sold) x Number of days in the accounting period.

*COGS = Beginning Inventory + Purchases – Ending Inventory

You can use 365 days in the calculation which is usually the period investors will use. A high DPO can indicate a business can delay payments to suppliers maximising cash flow. Or it can reflect a company not having the cash to pay its bills. If the company is financially sound with ample cash, then a high DPO is a good sign. A low DPO means a business is paying its bills quite fast. Investors need to dig deep into the analysis to determine whether the business is efficiently using its resources or is facing financial troubles.

(DSO) Days Sales Outstanding.

Days Sales Outstanding measures the amount of days a company takes to collect its cash. The formula to calculate this is:

(Accounts Receivables ÷ Net Credit Sales) x Number of Days

*Net credit sales are the amount revenue that has been paid using credit i.e. excluding cash sales.

Sometimes revenue is used, however we want to exclude cash payments as this can skew the results of the cash conversion cycle.

A low DSO means a business is collecting cash in a few days or a reasonable time frame. The faster a business collects cash the more financially stronger it will be. A high DSO can lead to challenges for a business as it means it will be outlaying cash to operate while waiting to be paid. A high DSO also means a company is selling more on credit which increases accounts receivables.

(DIO) Days Inventory Outstanding.

DIO measures the average number of days that a business holds onto inventory before selling it. The formula for this calculation is:

(Average Inventory ÷ Cost of Goods Sold) x Number of days in the period.

*Average Inventory = (Beginning Inventory + Ending Inventory) ÷ 2

A low DIO indicates that the business efficiently turns inventory into cash. This is positive as it allows the company to generate revenue faster. On the other hand, holding inventory for too long can tie up cash and increase costs for the business. Inventory liquidity is crucial for businesses. Rising inventory levels combined with a delayed DIO is not favourable. It’s important to look for low DIO as well as low inventory levels, which can indicate a highly efficient operation that minimizes the time between receiving inventory and selling it.

↩️ Working Capital Turnover.

The Working Capital Turnover ratio is a key metric that compares a company’s net sales to its net working capital. This ratio measures how efficiently a business uses its working capital to generate sales, unlike the working capital cycle which measures the time between cash inflows and outflows.

Investors should understand how effective a business is at producing revenue for every dollar of working capital deployed. A higher turnover ratio is preferred, as it indicates that the business is generating more sales for every dollar of working capital. On the other hand, a low turnover ratio reflects a business that is not maximizing its working capital efficiently.

The formula for Working Capital Turnover is simple:

Working Capital Turnover = Net Sales ÷ Net Working Capital (NWC)

Net Working Capital (NWC) measures the operating assets and liabilities of the business and I prefer this over working capital.

For example, if a business generates $100 million in revenue with a NWC of $15 million, its Working Capital Turnover would be 6.6 ($100m ÷ $15m = 6.6). This means that for every dollar of net working capital deployed, it earns $6.60 in revenue.

Several other turnover ratios can make up a core component of working capital. The 3 core ones are Accounts Receivable Turnover, Accounts Payable turnover, and Inventory Turnover. They all measure the efficiency at which a business turns over each of these areas. I find the working capital turnover to be the best.

In Summary…

I believe this rather lengthy explanation provides a reasonable understanding of working capital and its various components. When analysing a business, I focus a lot on working capital. However, I don’t spend time modelling working capital in valuation models because it can be challenging to predict changes as a business grows.

To understand working capital, I like to examine each line item and its relevance to operations, as well as the areas I’ve mentioned previously. Gaining insights into working capital offers a comprehensive view of the business and potential investment opportunities. Understanding a business’s working capital can better prepare you to make investment decisions.

Monitoring working capital when taking a position can help you understand the risks associated with the business. This allows you to track specific metrics related to cash inflows and outflows, providing insight into the business’s financial strength and whether it is equipped to scale efficiently.

In my own business experiences building and scaling companies, I was only ever under pressure when working capital became tight. So, as an investor, I focus on what I believe to be a fundamental area of business.

Working capital has implications for various other areas that drive a business’s success. Financing activities, investing activities, and ultimately free cash flow are all influenced by how well a business manages its working capital needs.

Ideally, a business with positive net working capital, a short cash conversion cycle, and a brief turnover period is the most favourable. Such businesses can withstand significant turbulence. The old entrepreneurial saying holds here: “Never grow the business out of money.”