Working capital is the day to day capital every organisation needs to continue its operations. Effective working capital management (WCM) is a complex balance between supplier and customer relationships, operational needs, financial efficiency, and reputation.
Simply defined, working capital is the surplus of our inventories and customer receivables (debtors), over our supplier payables (creditors). We bear the cost of giving credit to customers. Collecting cash more quickly from customers increases our cash and reduces our financing costs, but may have adverse effects on our sales volumes or prices.
When suppliers give us credit, that helps us and costs them. Paying our suppliers more slowly increases our cash and reduces our financing costs. But it risks damaging our relationships. It also risks adverse pricing from suppliers, and even harming our reputation. Intermediaries, supply chain finance and other solutions can provide win-win outcomes to some of these problems.
In the meantime, as treasurers we need to understand how any changes in our working capital will affect our cash and liquidity positions. We also need to be able to explain to colleagues in terms they understand. So let’s start with a case study framed around a frequent student question.
Case Study 1 – Accounting for working capital increase
(Q)
“I’ve been studying the indirect method of the cash flow statement and I understand the formula, but I am confused about how cash is affected in practice.
Using the indirect method for the cash flow statement, I have the following information:
Profit from the income statement: 45
- Increase in working capital: 20
= Net increase in cash: 25
The formula is shown as:
Profit for the period
+/- differences between profit and net cash flow
= net increase in cash
My confusion is with the adjustment for the increase in working capital. Why is the increase in working capital deducted from profit rather than added, especially when cash itself may not physically decrease?”
(A)
Working capital includes inventory and receivables from customers.
These items ABSORB cash. For example, if we buy inventory we will have LESS cash than we otherwise would have. Let's say we buy inventory for 20, and we haven't sold it yet. Cash goes down by 20 as a result of this transaction. Inventory goes up by 20. Working capital goes up by 20.
An additional 20 of our cash is now tied up in the form of working capital, reducing our cash. This is the reason that an INCREASE in working capital during a period REDUCES the amount of cash that we'd otherwise be enjoying at the end of the period.
In this case, we have a cash inflow of 45 from the profit for the period, offset by the working capital increase of 20, resulting in a net inflow of cash of 25 for the period.
Other changes in working capital – cash flow accounting
There are three main components to working capital: inventory, customer receivables (debtors) and supplier payables (creditors). Any of these components can go up or down during a period, giving us 3 x 2 = 6 possible individual changes affecting our cash.
We’ve seen what happens when our inventory goes up (above). Working capital went up, and cash went down. Now let’s review the other five possibilities in turn.
Case Study 2 - Inventory going down releases cash
This is the opposite situation to Case Study 1. For example, let’s say our inventory goes DOWN by 20 during the period in this case, with no other changes:
Profit from the income statement: 45
+ Decrease in working capital (inventory): 20
= Total increase in cash: 65
Reducing working capital RELEASES cash. For example, if we sell inventory we will have more cash than we otherwise would have. Let's say we originally bought inventory for 20, and now we’ve sold it. Cash goes up by 20 as a result of this transaction. Inventory goes down by 20. Working capital goes down by 20.
20 less of our cash is tied up in the form of working capital, reducing our cash on hand. This is the reason that a DECREASE in working capital during a period INCREASES the amount of cash that we have at the end of the period.
In this case we have an inflow of 45 from the profit for the period, PLUS the working capital decrease of 20, resulting in a total inflow of cash of 65 for this period.
Notice it’s the original cost of the inventory that’s reflected in the working capital movements. The related profit has already been dealt with in profit for the period.
Giving and taking trade credit
Giving trade credit means allowing our customers (debtors) to pay us later. Taking trade credit means we pay our suppliers (creditors) later. Changing the balances of trade credit given and taken will affect our cash flow. There are four possibilities.
Case Study 3 – Giving more credit to our debtors absorbs cash
Example:
Profit from the income statement: 45
- Increase in working capital (debtors): 15
= Net increase in cash: 30
Here we have granted additional trade credit to our customers (debtors) of 15. Our customers are holding 15 of cash that would otherwise be in our bank account. This is the reason our own cash is lower, by the amount of 15, than it otherwise would have been.
Our net increase in cash for this period is 45 inflow from the profit for the period OFFSET BY the 15 still held by our customers = net 30 inflow.
Case Study 4 – Reducing credit granted to debtors releases cash
We’ve seen how granting additional trade credit absorbs cash. Now let’s review the opposite situation.
Example:
Profit from the income statement: 45
+ Decrease in working capital (debtors): 15
= Total increase in cash: 60
Here we have reduced trade credit to our customers (debtors) by 15. We are now holding 15 of cash that would otherwise be in our customers’ bank accounts. This is the reason our cash is greater, by the amount of 15, than it otherwise would have been.
Our total increase in cash is 45 inflow from the profit for the period PLUS the additional 15 now collected from our customers = total increase in cash 60.
Case Study 5 – Taking more credit from creditors releases cash
The other side of the coin is our credit relationship with our suppliers (creditors). When our suppliers grant us more credit, we have more time to pay them, and we have more cash.
Example:
Profit from the income statement: 45
+ Decrease in working capital (increased creditors): 25
= Total increase in cash: 70
Here we have increased trade credit taken from our suppliers (creditors) by 25. We are now holding 25 of cash that would otherwise be in our suppliers’ bank accounts. This is the reason our cash is greater, by the amount of 25, than it otherwise would have been.
Our total increase in cash is 45 inflow from the profit for the period PLUS the additional 25 now allowed as trade credit by our suppliers (creditors) = total increase in cash 70.
Notice increasing our creditors here results in a DECREASE in working capital. This is because our creditors are a deduction when we calculate our working capital balance.
Case Study 6 – Reducing credit taken from creditors absorbs cash
The final possibility is when the trade credit taken from our suppliers is reduced. In other words, we are paying suppliers more quickly, reducing our cash.
Example:
Profit from the income statement: 45
- Increase in working capital (reduced creditors): 25
= Net increase in cash: 20
Here we have reduced the trade credit taken from our suppliers by 25. They are now holding 25 of cash that would otherwise be in our own bank account. This is the reason our cash is less, by the amount of 25, than it otherwise would have been.
Our net increase in cash is 45 inflow from the profit for the period MINUS the additional 25 no longer allowed as trade credit by our suppliers (creditors) = net increase in cash 20.
Notice reducing our creditors results in a INCREASE in working capital. As before, this is because our creditors are a deduction when we calculate our working capital balance.
Well done on honing your treasury skills by reading this article. Please continue making use of the ACT’s growing library of relevant resources, qualifications and practical training!
Author: Doug Williamson FCT
Other resources
Practical reporting for treasurers https://learning.treasurers.org/resources/practical-reporting-for-treasurers
Sustainability in practice for treasury https://learning.treasurers.org/resources/sustainability-practice-treasury