A Brief Definition of Working Capital

Working Capital as a financial ratio has two dimensions.

Traditionally it is part of the group of static liquidity ratios, which include assets and liabilities to reflect the capital structure of an enterprise. It is common practice to consider only short-term assets and liabilities, while Working Capital is defined as short-term assets (cash, accounts receivables, inventories, other receivables) minus short-term liabilities (accounts payables, other financial liabilities). The result should be positive, indicating that an enterprise owns adequate short-term assets to always ensure financial solvency.

In the modern corporate finance literature Working Capital is considered as an important measure and driver for capital efficiency. Consequently, the definition includes only short-term assets and short-term liabilities which have a close relation to the operational day-to-day business, e.g. accounts receivables, inventories and accounts payables. Sometimes this is also called Net Working Capital or Trade Working Capital.

Best practice: it is always necessary to put the definition in the right context of the sector. For example, in the capital goods industry or in construction it is important to include also advance payments into the definition.

How to Measure Working Capital

The most popular working capital ratios are the “how long does it take” ratios.

DSO = Days Sales Outstanding (accounts receivables / revenue x 365 days)

DPO = Days Payables Outstanding (accounts payables / cost of material x 365 days)

DIO = Days Inventories Outstanding (inventories / revenue x 365 days)

Example: if an enterprise has EUR 60 million accounts receivables, while the annual revenue is EUR 250 million, it takes on average 88 days to cash in the money from the debtors.

The financial ratio which summarizes the three above mentioned detail ratios is the Cash Conversion Cycle. This ratio describes how long it takes an enterprise to convert money from being initially invested into business until a payback through a client. CCC is calculated by adding DIO and DSO together and substracting DPO from the sum.

Calculating the Cash Conversion Cycle

Cash Conversion Cycle CRX Markets

How to calculate the Cash Conversion Cycle:

CCC = DIO + DSO – DPO

CCC = 35 + 23 – 67 = -9

Note: A negative cash conversion cycle of -9 means the company can hold on to its cash for 9 days before it has to pay its suppliers.

Working Capital Benchmarks as a first approximation

There are numerous players in the consulting industry who constantly conduct and publish working capital studies, frequently either with a sectoral focus, e.g. “PWC Working Capital Automotive Study”, or with a regional focus “Working Capital in the DACH region”. This already flags that benchmarking working capital is anything but trivial, because working capital relevant market practices can differ significantly. However, these studies frequently offer a fair point of first approximation, how the world outside looks like and if there are major discrepancies, worth to dig deeper.