Understanding Working Capital

Working Capital can be thought of in two ways: -Obvious: The amount that current assets exceed current liabilities (current assets - current liabilities) -Less obvious: The amount that your current assets are financed by capital sources OTHER than current liabilities (if amount of current assets exceeds the current liabilities, then the remaining financing source for those current assets would have to be long-term debt or equity)

Since long-term debt is often already directly deployed to support long-term assets (buildings, land, equipment, etc.), working capital can be viewed as the amount of equity a company has in its current assets.

More working capital is typically viewed favorably by lenders because your accounts receivable and inventory, given sufficient time to convert to cash, are more than sufficient to extinguish current liabilities (covering all vendor payables or paying down a bank line of credit).

Too much working capital could be viewed negatively by shareholders if a company would be better off borrowing on a line of credit to support its current assets, freeing up the company's equity to be used elsewhere (new projects, dividends, etc.).

Days outstanding is referring to the CCC formula you cited. The DIO, DSO, and DPO formulas all have important implications for financial projections because once you have revenue and gross margin projected on the income statement, you can derive your projected balance sheet accounts for AR, Inventory, and AP using the days outstanding formulas. Benchmarking against historical DIO, DSO, and DPO and against comparable companies is also an important practice to understand your target company's working capital management.

Inventory days is how long it takes the average $ of Inventory to convert to convert into sales. A shorter number of Inventory days means inventory is turning quickly and being sent out the door as sales. Certain products may convert into sales quickly, while other products may sit on the shelves for months without producing revenue and may even become obsolete requiring write-downs.

AR days is how long it takes a company to collect its cash once a sale has been made. A shorter number of AR days means that AR balances are collected quickly. It's important to calculate this as (AR/Credit Sales)*365 if some sales are settled in cash immediately with no resulting AR balance. Calculating AR days using only the sales amount that actually resulted in an increase in AR is most appropriate.

AP days is how long it takes a company to pay outstanding accounts payable. A shorter number of AP days means a company is paying its vendors quickly. Companies will often "stretch" its AP days by taking longer to pay vendors in order to preserve cash, but at the detriment of upsetting vendors and possibly receiving less favorable terms in the future. Note: I think investopedia does an excellent job of explaining each of these and the CCC further and has a great video summary.

Working capital for retailers has additional wrinkles because when inventory is sold, sales are largely collected in cash immediately, with no account receivable recognized. Vendors would still have standard invoice payment terms of ~30 days. In such a case, working capital could very well be negative. The AP outstanding balance as a source of capital exceeds the inventory asset balance, ~0 AR balance, and the collected cash from sales is deployed elsewhere and does NOT accumulate as a current asset on the balance sheet. That said, a retailer will need a certain minimum amount of current assets held as cash to keep cash in the registers.

So...yeah... current assets - current liabilities = working capital.

Slow day at the office.