Financial statements course · Lesson 6 of 10
Working capital is cash that waits inside the business.
A company pays for its goods before its customers pay for them. The money in between is working capital. When the company grows, that money grows too.
The lines
| Line, $ millions | Start of year | End of year | Cash effect |
|---|---|---|---|
| Receivables | 111.1 | 120.0 | (8.9) |
| Inventory | 83.3 | 90.0 | (6.7) |
| Payables | 55.6 | 60.0 | 4.4 |
| Accrued expenses | 27.8 | 30.0 | 2.2 |
| Deferred revenue | 18.5 | 20.0 | 1.5 |
| Working capital | 92.6 | 100.0 | (7.4) |
Assets in working capital use cash when they grow. Liabilities give cash when they grow. Example Co. grew 8%, so each line grew 8%. The net cost was $7.4 million of cash.
Days, not dollars
A balance in dollars grows with the company. A balance in days does not. Days show if the terms with customers and suppliers changed.
| Measure | Formula | Days |
|---|---|---|
| Days of sales in receivables | Receivables / revenue × 365 | 43.8 |
| Days of inventory | Inventory / cost of goods sold × 365 | 59.7 |
| Days of payables | Payables / cost of goods sold × 365 | 39.8 |
| Cash cycle | Receivables days + inventory days − payables days | 63.7 |
Example Co. waits 44 days for its customers to pay. Its goods stay 60 days in stock. It pays its suppliers after 40 days. So each dollar of cost waits 64 days before it comes back as cash.
These formulas use the balance at the end of the year. Some analysts use the average of the start and the end. Use one method for all years.
What ten slow days cost
Suppose that customers take 10 more days to pay. At revenue of $1,000 million, receivables grow by $27.4 million. That cash stays with the customers. It is 26% of Example Co.’s free cash flow, and net income does not change at all.
Deferred revenue is the good kind
Deferred revenue is cash from customers who paid early. A company with a lot of it gets paid before it delivers. Subscription software companies often work this way. Their working capital can be less than zero, so growth gives them cash.
Key points
- Working capital grows when the company grows, and the growth uses cash.
- Track days, not dollars. Days show changes in terms.
- Slower customers cost cash, but the income statement does not show it.