Working capital and cash flow are closely connected. To operate properly, a business must have sufficient available funds to finance its operations: raw materials purchases, trade receivables, etc. This is where working capital comes in, as it is basically your company's “nest egg”!
If you would like to know what working capital is, how to have a healthy working capital, and how to calculate it, read on to learn the basic principles of WC.
Working capital (WC) is an accounting metric that shows, in figures, how a business uses its money. This is a very important concept in terms of cashflow management. In practical terms, this metric represents the funds available to a business to pay its running expenses (suppliers, staff, operating expenses) until it obtains payment from its customers.
Also known as overall net working capital (ONWC), working capital is the capital you use to meet your financial obligations on a daily basis.
Having visibility of your working capital allows you to run your business more efficiently because you know in advance what expenses you can cover without resorting to a loan.
In practical terms, keeping an eye on this metric allows you to sustainably finance the investments that your business cannot do without.
Originally, working capital was used to assess a business's solvency by working out the difference between its most liquid assets (inventories, receivables and cash in hand) and its short-term liabilities or the difference between its long-term funds (equity and borrowings) and its fixed assets. If the difference was positive, the company's financial balance was considered satisfactory.
In the 1970s, theanalysis of financial balance was fine-tuned and to assess it, the amount of working capital calculated was compared with the company's recurring financial requirements generated by its operations. This became known as the working capital requirement (WCR).
Today, this accounting instrument measures the funds a business has in the medium and long term to finance routine operations, outside its turnover. It gives a precise view of the financial health of your business in order to manage it confidently and build your development strategy. To optimise cash flow, this “reserve” must be adapted to the operating cycle of your business at all times. Key takeaway: the working capital must be sufficient to partly cover the working capital requirement (WCR) in order to support and maintain the operating cycle.
Although these are two key concepts for a business, they are both interlinked and distinct.
👉 What is Working Capital Requirement (WCR) ?
- Working capital requirement is the money a company needs at a given point in time,
- whereas working capital is used to determine whether the long-term funds are sufficient to finance the fixed assets (durable assets).
Working capital is linked to the balance sheet whereas working capital requirement relates to the short-term financing of a business.
To fully understand:
- Working Capital Requirement: amount the business needs to cover its operating expenses;
- Working Capital: amount the business possesses to pay its operating expenses.
A working capital calculation is needed in three precise situations:
- When starting up a business: to define the necessary share capital and the amount of bank loans needed.
- At specific times during the existence of a business: before launching new products, to anticipate the opening of a sales outlet, before a recruitment phase, etc.
- When selling a business: in this context, the working capital not only provides proof of financial strength but also helps to estimate the most coherent sale price.
Working capital is calculated based on the information found in the balance sheet. The balance sheet lists the assets and liabilities of your business.
In the example above, it is split into two parts: top and bottom. The top of the balance sheet is the part containing all of a company's long-term items (available for more than one year), whether assets or liabilities. It precisely sets out the investment capital and long-term uses.
The two calculation methods below are based on what is referred to in France as the top of the balance sheet.
Calculation method 1: Overall net working capital (ONWC) = equity - fixed assets
However, on a day-to-day basis, a different formula is more often applied:
Calculation method 2: Overall net working capital (ONWC) = investment capital - long-term uses
In this formula, the investment capital includes:
- financial debts,
- provisions for contingencies and charges.
And long-term uses correspond to gross fixed assets. Calculating working capital using current assets and liabilities This formula is based on the current assets and liabilities in the balance sheet. Unlike the equation above, it measures it in the short term (less than a year).
Overall net working capital (ONWC) = short-term assets - short-term liabilities
Short-term assets include:
- current assets
- cash in hand
Short-term liabilities include:
- current liabilities
- short-term debts
Why a company director should focus on the long term
Even though it might seem less urgent to monitor these long-term items, as a company director or CFO, you should not overlook them. Because having a regular analysis allows you to optimise your cash flow, develop or diversify your business and even reduce your debt.
Overall net working capital (ONWC) breaks down into three main categories.
Capital funds represent the business's own resources. They come from the profits made by the business itself or inputs from investors. These available financial resources help support the investments and operating cycle of a business. The more capital funds a business has, the more its value is boosted.
- If capital funds are positive: the business has financial reserves to make long-term investments such as: machinery, but also to finance the business activity: expenditure on goods, book credit, etc.
- If equity is negative: this means that its value is zero or even negative and implies that the business has made a loss in previous years. In this context, the business must build its equity back up. Juridiquement (article L. 223-42 du Code de Commerce), vous disposez de 2 ans pour reconstituer votre capital en cas de pertes.
Loan capital represents the amounts granted by a financial institution in the form of instalment loans. In fact, it often corresponds to borrowings and toshareholders' loans that are blocked over the medium or long term.
Fixed assets, which can also be called long-term assets, mean those of the company's assets that are intended to be retained over the long term.
Fixed assets break down into three categories: intangible, tangible (property, plant and equipment) and financial (permanent investments.
Property, Plant and Equipment Once they are completed, they are entered in the balance sheet under the following line items:
- land, including fixtures and improvements;
- buildings: general facilities, structures and infrastructure;
- technical facilities, equipment and machinery.
Until they are completed, property, plant and equipment are entered in a work-in-progress item.
Intangible fixed assets include:
- preliminary expenses;
- research and development costs;
- concessions, patents, licences, trademarks and software; they represent the investments in intangibles made by the business;
- The goodwill consists of intangible items, including lease rights.
- Equity interests such as shares for example;
- Loans granted to staff or shareholders;
- Debt securities;
- Deposits and guarantees.
The company Smith & Jones has the following accounting data for 2020: 150,000 Euros equity 300,000 Euros of fixed assets
Here is the formula for calculating the working capital:
150,000 - 300,000 = - €150,000 ONWC
Financial Analysis: Here, we therefore have a negative ONWC. The funds available to Smith & Jones will not be sufficient to cover the operating expenses.
There are two possible solutions: find new financing or review the company's strategy.
There are three possibilities with working capital: depending on the result, it may be above zero, below zero or equal to zero.
When the net working capital is positive, this means that the business generates a cash surplus, which allows it to finance all or part of the structural portion of its working capital requirement (WCR). When it is calculated over the long term, a positive WC proves that the business has stable resources.
Conversely, when a positive working capital is calculated over the short term, it means that debts can be paid by realising short-term assets.
When a business has a negative working capital, it is described as undercapitalised. This is a risky situation, as the business is unable to bear all of its investments. If the working capital is negative over the long term, this implies that the resources will not be sufficient for the business to operate correctly. If the working capital is negative in the short term, then the business is unable to pay its debts, even if it realises its assets.
Zero ONWC means that the business has no long-term cash advance and this undermines its financial balance by making it insecure.
Net cash encompasses all liquid assets that are available in the short term; in accounting jargon, this is known as the “sight balance”. Link between net cash and working capital Net cash corresponds to the cash assets of a business less the financing of working capital (ONWC) and working capital requirement (WCR).
Net cash is calculated using the following subtraction:
Net cash = working capital - working capital requirement or ONWC - WCR
This formula is the most frequently used; it corresponds to the approach by long-term assets and liabilities.
Net cash is calculated either: Before taking over or founding a business By calculating net cash when developing a business plan, the viability of a project can be checked for example.
Or during the life cycle of a business As CFO or Company Director, you may wish to track this management metric on a daily, weekly or monthly basis.
By carefully monitoring your net cash:
- you measure your short-term financial balance;
- you guarantee efficient and sustainable management;
- you have visibility over your future investments;
- you have a reference to develop your budget forecast.
There are several reasons why a business may experience areduction in working capital. The most common are:
When a business loses a significant part of its turnover, this directly impacts its equity, in other words its cash flow and, therefore, its liquid assets.
This mechanism inevitably entails a reduction in working capital, with a decline in cash flow.
This loss of turnover may be temporary and due to a one-off event. If this is the case, the situation can be turned around by adopting a different strategy, revising the pricing policy, diversifying the products or services or targeting new customers for example. In general, to turn a business's financial situation around, a loan needs to be taken out over three to five years to reinforce the capital funds.
Two means of financing are available to a business:
- either by using external funds: borrowing, raising capital, etc.
- or by using its capital funds, which is known as self-financing.
Businesses sometimes self-finance their investments to avoid resorting to a loan. This is a tricky choice as it can weaken a healthy cash position and reduce the working capital.
By opting for this solution, you increase your long-term needs without offsetting your investment capital. Generally, it is therefore wiser to finance an investment by means of a capital increase or a bank loan.
By definition, dividends correspond to the profits generated by a business. These earnings are levied directly from the company's profits to be paid to shareholders: this is known as dividend distribution.
This distribution impacts the cash position, as it entails a disbursement and reduces the company's equity. The cash actually available should therefore be taken into account to optimise the dividend distribution.
In other words, if you pay less than the profit you increase the working capital; otherwise, you delve into your reserve funds.
In order to anticipate these variations, it is highly recommended to make a cash flow forecast.
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