Lending 101 - Demystifying working capital

Concept of Operating Cycle

Companies make money through utilization of its assets. From the point the company invests in an asset to the point when it generates cash from this investment, it is called the "asset conversion cycle“. In any asset conversion cycle, it consists of:

1) Operating Cycle - this addresses short-term assets and

2) Capital Investment Cycle - this relates to long term asset.

Let me give an analogy using an example of operating an income-producing property:

• In the day to day operation of the property, it usually involves paying maintenance expense (cleaning, handyman, hydro, insurance, property management, etc) and property tax. These expenses are expected to be covered or partially covered by rental income. From a dollar out to pay for these operating expenses to that dollar in from the tenant, this is the operating cycle.
• When the property needs to be renovated to support better operation (e.g. attracting new tenants), it is considered a long-term asset investment and the return will be realized in a longer term (an IRR is usually calculated to determine whether this investment justifies the return). This will count towards a capital investment cycle.

Working Capital Defined

The working capital ("WC") concept is strictly related to the operating cycle of the company; its technical definition is the difference between current assets and current liabilities. Typically, a fiscal year of a company is comprised of several operating cycles, with repetitive activities of raw material purchase, inventory production, sales, and finally AR collection. In a software company, it would be the process of signing a contract, collecting upfront subscription fees, rendering the service, and paying the vendor/employees.

The main reason why WC needs to be managed is because WC arises from the timing difference in an operating cycle. When goods are sold and services are rendered, the timing of cash collection often times do not match exactly when the costs are incurred and paid.

How to measure the management of WC

There are two ways to measure how well Working Capital is being managed.

1) Operating Efficiency - By the number of days on average an operating cycle takes, calculated by days sales outstanding minus the days payable outstanding (for simplicity, days of inventory outstanding is left out of this discussion). The shorter the days are, the more efficient the company's cash conversion ability is. The number of days is also benchmarked against its historical trend or peers to determine whether WC management is efficient. For example, software companies usually do not have inventory and do not have large account receivables (subscription fee paid upfront), the cash conversion days is likely negative, indicating a business model with strong cash flow conversion capability.

2) Liquidity - by the calculation of the current ratio. The company's most ideal situation would be that at any point in time, the combined current asset (cash + AR + Inventories) is sufficient to cover the current liabilities (AP + Accruals) - i.e. current ratio is 1x and above.

Implication of when current ratio is below 1x

1) Short term liquidity concern: there is a very simplified assumption here that the company will have a challenge to meet the next 12 months of obligations and this could give rise to a "going concern" note if the company's financial statement is audited.

2) Further digging is required: How will the company finance the shortfall between current assets and current liabilities? In non-accounting terms, this could mean that the cash and the amount of receivable collected wouldn't be enough to pay the vendor invoices coming due and payroll. In this case, we need to ascertain whether the company has access to capital to address this shortfall. This could mean:

a) Any measures the company is taking to extend the APs coming due as a band-aid solution?

b) Any availability in their operator line/working capital loan?

c)Is the company taking measures to boost sales in order to generate more current assets?

d) Any other ways to raise funds to address the liquidity tightness?

3) Monitor the trend: As we all know, balance sheet items are a point-in-time snapshot of the company's operation, it doesn't depict the full picture of the company. Ideally, evaluate the working capital changes on a monthly basis and an accumulative basis year over year. Companies operating in a stable state have fluctuating working capital changes which is normal. What is not normal is that the working capital is consistently having a large disparity. A significantly higher current liabilities over current assets indicates that the company is not generating enough sales to cover its operating expenses. A much higher current asset over current liabilities (other than cash balance) could indicate that the company is not converting inventories or AR fast enough or it could be a sign of fraud.

How can an operator help with WC management

• An operator (or revolver) is best used to tackle the timing difference between cash outflow to vendors and cash inflow from customers. The debt facility is expected to revolve, with periodic drawdowns and repayments. The quantum can be determined by calculating the cash conversion cycle and determining how much cash outflow is needed to bridge these cycles. A cushion is necessary - think about an ideal current ratio of 1.5x and above.
• Suppose the working capital shortfall is not arised from a timing difference. In that case, it is an indication that a permanent working capital is required to put the company back to a healthy financial state. A term debt with a longer tenor and amortization or even equity injection would be a better financing solution to address the shortfall.