Working capital explained

Summary

This video explains the concept of working capital with an intuitive approach. Through a children’s toy business example, it compares high vs. low working capital needs, showing how different operational strategies impact cash flow and financing needs. The video delves into the relationship between working capital and cash, providing real-life examples of 3M and Microsoft’s working capital calculations. It emphasizes how managing working capital effectively can improve cash flow and increase return on assets, concluding with practical insights for businesses aiming to optimize their finances.

Takeaways

• 😀 Working capital is the total amount of capital invested into a company's operating cycle, including its day-to-day activities like buying, holding, and selling inventory.
• 😀 High working capital needs, like paying suppliers upfront and offering extended customer credit, can lead to lower cash flow and require external financing.
• 😀 Low working capital needs, such as extending supplier terms and reducing inventory, can improve cash flow and reduce the need for external financing.
• 😀 A business can improve cash flow and return on assets by managing working capital efficiently, such as by shortening payment terms or increasing inventory turnover.
• 😀 Negative working capital can be beneficial for some companies, as it means suppliers and customers are financing the company's operations.
• 😀 For 3M, the calculation of working capital at the end of 2018 was $7.1 billion, derived from accounts receivable, inventory, and accounts payable.
• 😀 Microsoft had a negative working capital of -$12.1 billion in 2018, largely due to unearned revenue, which reflects payments received for future services.
• 😀 Unearned revenue is a liability for companies like Microsoft and is an important factor in calculating working capital, especially for businesses with long-term contracts.
• 😀 High working capital usually means a company is holding a lot of inventory or offering extended credit to customers, which can strain cash flow.
• 😀 Managing working capital effectively can help businesses avoid liquidity problems and free up cash for reinvestment or paying down debt.
• 😀 Efficient working capital management helps businesses maintain smoother operations, better cash flow, and ultimately higher profitability.

Q & A

What is working capital?

Working capital is the total amount of capital invested in a company's day-to-day operations, including expenses related to inventory, accounts receivable, and accounts payable.

How can working capital affect a business's cash flow?

Working capital affects cash flow because higher working capital means more money tied up in inventory and receivables, reducing available cash. Conversely, lower working capital can improve cash flow by reducing these holdings.

What are the implications of having high working capital?

High working capital means a company needs more financing (debt or equity) to fund its day-to-day operations, which can reduce cash flow and return on assets.

What are the benefits of having low working capital?

Low working capital reduces the need for external financing and improves cash flow. It can also lead to a higher return on assets, as cash is freed up and can be used more effectively.

How does paying suppliers quicker impact working capital?

Paying suppliers faster increases working capital because it reduces the company's available cash, meaning more financing may be needed to fund the operational cycle.

What is the effect of holding more inventory on working capital?

Holding more inventory increases working capital, as cash is tied up in stock. This may lead to a lower cash balance, affecting liquidity and requiring more financing.

Why is extended customer payment terms detrimental to cash flow?

Extended customer payment terms increase working capital by delaying cash inflows, which can reduce available cash and necessitate additional financing for ongoing operations.

What is the difference between high and low working capital using the toy business example?

In the toy business example, high working capital (Option A) means paying suppliers immediately, holding high inventory, and offering extended payment terms to customers. Low working capital (Option B) involves getting more favorable supplier terms, using Just In Time inventory, and collecting customer payments upfront.

What does a negative working capital balance mean, and is it always a bad thing?

A negative working capital balance means the company is relying on suppliers and customers to finance its day-to-day operations. It is not necessarily bad, especially in businesses like Microsoft, where advance payments (unearned revenue) reduce the need for external financing.

How do 3M and Microsoft’s working capital calculations differ?

Both 3M and Microsoft calculate working capital by adding accounts receivable and inventories, then subtracting accounts payable. However, Microsoft also includes unearned revenue, which results in a negative working capital balance, indicating that suppliers and customers are helping finance its operations.