Creditors and shareholders look in every nook and corner before putting their money in any company.
Some even look into the dustbin of the company. The shareholders and creditors want to know whether their money is ultimately landing in the company’s dustbin. But those who can’t bother getting their hands dirty can look at another indicator: the management of working capital by the company. It can tell us, in a nutshell, how well the company is managing its day-to-day operations. Today, our friends Jinny and Johnny are talking about the usage of working capital by any company.
Johnny: Jinny, where are you? Why are you hiding from me?
Jinny: I was just trying to surprise you. Don’t think I want to play hide-and-seek.
Johnny: I know you don’t like to play hide-and-seek but sometimes companies do play that game with their lenders when it is time to pay back a loan.
Jinny: What is making you so concerned about companies and their lenders so early in the morning?
Johnny: Well, Jinny, a few weeks back you told me about various liquidity ratios, the favourite tools of assessment used by lenders. That day I wanted to ask you about one more term that I frequently hear lenders talking about. That is working capital. What does working capital mean?
Illustration: Jayachandran / Mint
Jinny: It is good to see you interested in understanding new terms. Apart from fixed assets such as land, buildings and machinery, a company also requires working capital to produce goods and services. So, working capital is the resource that companies need for their day-to-day business operations. A company that makes ketchup requires fresh tomatoes, various spices, salt and many other raw materials. A car-manufacturing company requires steel and other raw materials. Without working capital resources, these companies can’t carry out their business. Mathematically, working capital is the difference between the current assets and current liabilities of the company.
As you know, current assets include things such as cash and bank balances, investment in different securities, money receivables, short-term loans and advances, inventory of raw materials, stock in progress and finished goods, etc.
On the other hand,current liabilities include all short-term borrowings that are repayable within one year — instalments and interests of term loans, deposits maturing within one year, sundry creditors for raw materials, stores and consumable spares, etc.
A positive working capital may mean that the ketchup company is financially well placed to buy tomatoes. A negative working capital may mean that the ketchup company is in trouble.
However, one should not immediately jump to such conclusions. Very low working capital is not always a bad sign, nor is very high working capital a good sign. The conclusion always depends on which company you are analysing. Striking a balance is always important.
Johnny: What kind of balance are you talking about?
Jinny: High working capital may be due to a high level of current assets such as inventories and cash receivables. On this basis, we can draw many conclusions. Maybe the ketchup company is buying more tomatoes than is actually required, or maybe the company is not able to sell the ketchup in the market, or maybe the wholesalers are not paying back the company in time. None of the conclusions is a good sign if you are an investor in the company. So, very high working capital is not always good for a manufacturing company.
Further, a company doing retail trade typically requires less working capital than a manufacturing company. This is so because retailers do not require raw material for producing anything. They obtain most of their goods from manufacturers on credit.
So, low working capital is not a bad sign for a company in the retail business. Some retail companies selling their products online may actually work on a negative working capital requirement.
Johnny: How can any company work on negative working capital?
Jinny: Let us take an example. Companies selling goods online obtain payment of their goods online from buyers before themselves placing an order with suppliers. There is no need to place goods on the shelf. You just need to manage the supply chain.
How much working capital do you need for that? Of course, some current assets in the form of cash would be required, but if a substantial number of purchasers are paying you in advance, for which the delivery is to be made with a time lag, then your current liabilities would exceed your current assets, making the working capital negative. So, how much working capital a company truly needs would vary from company to company. If you want to further analyse how well the company is managing its working capital, then maybe you can take a look at the cash conversion cycle of the company.
But understanding the cash conversion cycle requires some mathematical exercise.
Johnny: Cash conversion cycle? Mathematics? Jinny, let us leave counting days and numbers for some other time.
What: The working capital of a company is the difference between its current assets and current liabilities.
Why: Working capital is required for the day-to-day business operations of a company.
When: Negative working capital is a situation in which current liabilities of a firm exceed its current assets.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at firstname.lastname@example.org