What is working capital?According to Brigham (1999), working capital is a company's investment in short-term assets. For Assaf Neto (2005), the concept of working capital (or circulating capital) is associated with the resources that circulate, or turn over, in the company during a given period. In other words, it is the portion of capital invested in the operating cycle: cash, accounts receivable from customers and inventories. The part of this working capital that is financed with long-term funds (own or borrowed), rather than with short-term debt, is called net working capital, which we will see in the calculation further below.Working capital plays a major role in companies' operating performance; in many trading and manufacturing companies, it accounts for more than half of total assets. Falling sales, rising customer defaults, higher financial expenses and rising costs are some of the factors that show how important it is to manage it well.Good working capital management especially helps small businesses: with a sound financial strategy, resources are left over to invest in the company itself or in new ventures. Once a company starts operating, working capital demands the financial manager's constant attention, because lack of control over cash inflows and outflows is among the main reasons businesses close.Working capital is not the same as profitability. Profitability can wait for profits to recover; working capital cannot. It is a priority: without profit the company stagnates or shrinks, but without working capital it disappears. And it is strongly affected by the uncertainties of any business activity.For this reason, the company should keep a financial reserve to face the unexpected. The reserve should be sized according to the needs of the operating cycle and the risks of the business: too small, and the company is exposed to cash crises; too large, and money sits idle, at an opportunity cost. Hence the company's concern with how much cash and cash equivalents it holds.Cash and cash equivalentsUnder CPC 03 (R2), the Brazilian pronouncement equivalent to IAS 7, cash equivalents are held to meet short-term cash commitments, and not for investment or other purposes. For an investment to qualify as a cash equivalent, it must be readily convertible to a known amount of cash and subject to an insignificant risk of changes in value. Therefore, an investment normally qualifies as a cash equivalent only when it has a short maturity, for example, three months or less from the date of acquisition.Investments in equity instruments (shares and other ownership interests) are not cash equivalents unless they are, in substance, cash equivalents, as in the case of redeemable preferred shares with a defined, short redemption date.Bank borrowings are generally financing activities. However, negative bank balances arising from overdrafts or secured credit lines, which are repaid in the short term and form part of the entity's cash management, are included as a (negative) component of cash and cash equivalents. A characteristic of these arrangements is that the bank balance often swings between positive and negative.Cash flows do not include movements between items that are already cash or cash equivalents, because these movements are part of the entity's cash management, not of its operating, investing or financing activities. Cash management includes investing excess cash in cash equivalents.Which of these items qualifies as a cash equivalent under CPC 03?Answer: A bank deposit certificate with daily liquidity and an insignificant risk of changes in value — a cash equivalent must be readily convertible to a known amount and carry insignificant risk. Listed shares are liquid, but their price fluctuates, so they do not qualify.How to reduce the need for working capitalIn addition to keeping the financial reserve, the following measures help eliminate or prevent a shortage of working capital:Control customer defaults: according to Assaf Neto (1997), customer defaults can result from the country's general economic situation or from factors within the company itself. In the first case, an economic downturn tends to increase defaults, and the company has little control over the problem. When defaults come from the company's own inadequate credit practices, the solution is less difficult: basically, paying more attention to the quality of sales than to their volume.Don't finance working capital at any cost: according to Santos (2001), in an attempt to make up for a shortage of working capital, many companies turn to expensive loans. As a rule, money raised at a real cost above about 1.17% per month (equivalent to 15% per year, since 1.0117 to the 12th power ≈ 1.15) is incompatible with the profitability the author considers normal, 15% per year in real terms. If the debt costs more than the business earns, the loan solves the immediate cash problem but creates another: the difficulty of repaying it. These percentages are the author's benchmark; always compare the cost of debt with the real profitability of your own business.Lengthen the debt profile: Santos (2001) notes that when a company manages to negotiate longer terms to pay its debts, it postpones cash outflows and improves its working capital position. The help is temporary, but it buys time for the economic situation to improve. Here too, the cost of the extension must be watched, as it has to fit within the company's profitability.Cut costs: Brigham (1999) warns that a cost-reduction program improves working capital, provided it does not restrict sales or the running of operations. Since a company with a working capital problem usually also has limited capacity to invest, cost reductions that require investment (modernization, automation, computerization) tend to be out of reach. In a working capital crisis, cutting costs is mandatory, and the great challenge is to identify the expenses that can be cut without much harm to the business.Shorten the cash conversion cycle: for Gitman (2001), when a company shortens its operating cycle (holding inventory for less time and collecting faster) or lengthens its payment period to suppliers, its need for working capital decreases.Calculating working capitalThere are two different measures, which many people confuse.Net working capital (NWC) — in Brazil, CCL (capital circulante líquido) — shows how much of current assets is financed by long-term funds:NWC = Current Assets − Current LiabilitiesThe same amount can be obtained from the long-term side: NWC = (Equity + Non-Current Liabilities) − Non-Current Assets.The working capital need (WCN) — in Brazil, NCG (necessidade de capital de giro) — looks only at the accounts linked to operations and shows how much money the operation "ties up":WCN = (Accounts Receivable from customers + Inventories) − (Suppliers + other operating payables, such as salaries and taxes)When the WCN is greater than the NWC, the difference has to be covered with short-term loans — and it is this difference that usually leads companies into cash squeezes.A company has current assets of R$ 500 thousand and current liabilities of R$ 300 thousand. In operations, it has receivables of R$ 200 thousand, inventories of R$ 150 thousand and suppliers of R$ 120 thousand. What are the NWC and the WCN?Answer: NWC of R$ 200 thousand and WCN of R$ 230 thousand — NWC = 500 − 300 = 200; WCN = 200 + 150 − 120 = 230. Since the WCN exceeds the NWC by R$ 30 thousand, that part of the operation is being financed with short-term debt.The cash conversion cycle and the working capital needThe need for working capital arises when the cash conversion cycle is positive, that is, when the company pays its suppliers before collecting from its customers and has to "fund" that interval. In the figure below, the goods are bought on day 0, sold on day 30 and collected on day 60, but the supplier is paid on day 40: the 20 days between payment and collection (60 − 40) have to be financed with working capital.Cash conversion cycle (days) = supplier delivery time (days) + production time (days) + inventory period (days) + customer collection period (days) − supplier payment period (days)Delivery time only enters the calculation when the supplier payment period is counted from the order date rather than from the arrival of the goods; and production time only exists in manufacturing. For a trading company, the classic formula is: cash conversion cycle = average inventory period + average collection period − average payment period.In practice, average periods are used:Calculate the average payment period to suppliers: if half of purchases (by value) are paid in cash and half in 30 days, the average is 15 days. There may be other terms; in that case, weight each term by the amount paid under it;Calculate the average collection period from customers: if half of sales (by value) are collected in 30 days and half in 60, the average is (30 + 60) ÷ 2 = 45 days.Assuming, for simplicity, that goods are sold as soon as they arrive (zero inventory period), the company takes 45 days to collect from customers and 15 days to pay suppliers. In other words, there are 45 − 15 = 30 days of operation to be funded by working capital.This does not mean the company needs a single supplier payment sitting in the account. Since purchases and sales happen continuously, on any given day it is funding all the purchases of the last 30 days. So a simple estimate is: working capital need ≈ average daily purchases × cash conversion cycle in days = monthly purchases × (cash conversion cycle ÷ 30). If the company buys R$ 10 thousand a month and the cash conversion cycle is 30 days, it needs about R$ 10 thousand of working capital.Example 1A trading company's own working capital is R$ 4 million. Its cash conversion cycle is 15 days and its monthly purchases, at cost, are R$ 8,590,909. To keep working with suppliers and customers under the same conditions, the company needs R$ 8,590,909 × 15 ÷ 30 = R$ 4,295,455 of working capital. It therefore has to finance R$ 4,295,455 − R$ 4,000,000 = R$ 295,455.Example 2Continuing the previous example: the company managed to extend its payment period to suppliers by 3 days, cut its collection period from customers by 3 days and eliminate a 5-day loss in delivery. The cash conversion cycle drops from 15 to 15 − 3 − 3 − 5 = 4 days. The working capital need becomes R$ 8,590,909 × 4 ÷ 30 = R$ 1,145,455. As a result, the company no longer needs credit and also frees up R$ 4,000,000 − R$ 1,145,455 = R$ 2,854,545 to invest.A store holds goods in inventory for 30 days, collects from customers in 45 days and pays suppliers in 35 days. It buys R$ 60,000 per month. What is the estimated working capital need?Answer: R$ 80,000 — cash conversion cycle = 30 + 45 − 35 = 40 days; WCN ≈ 60,000 × 40 ÷ 30 = 80,000. R$ 150,000 would come from using the 75-day operating cycle and forgetting the suppliers' term.Calculating the cash conversion cycle of complex operationsWith a single product and a single supplier, the calculation is simple. But what about a company with many products? In that case, you build a table with the cash conversion cycle of each product (periods in days).NameSupplier payment periodCustomer collection periodDelivery timeInventory periodCash conversion cycleProduct 1303552131Product 245350144Product 1: 5 + 21 + 35 − 30 = 31 days. Product 2: 0 + 14 + 35 − 45 = 4 days.NamePurchases per month (at cost)Cash conversion cycle (days)Product 1R$ 10,000.0031Product 2R$ 20,000.004The total need is the sum of each product's need:Working capital for Product 1: R$ 10,000.00 × (31 ÷ 30) = R$ 10,333.33Working capital for Product 2: R$ 20,000.00 × (4 ÷ 30) = R$ 2,666.67Total: R$ 13,000.00This sum is not an overestimate: with purchases and sales happening every day, each product permanently keeps its own amount "tied up" in the cycle, and the money of one is not free to pay for the other. It is equivalent to computing the average cash conversion cycle weighted by purchases: R$ 13,000 ÷ R$ 30,000 per month × 30 = 13 days. Where diversification helps is with fluctuations: purchase peaks for one product may coincide with collection peaks for another, which reduces the extra reserve for the unexpected — but not the average working capital need.A company buys R$ 30,000 per month of product A, with a 10-day cash conversion cycle, and R$ 15,000 per month of product B, with a 40-day cycle. What is the total working capital need?Answer: R$ 30,000 — product A: 30,000 × 10 ÷ 30 = 10,000; product B: 15,000 × 40 ÷ 30 = 20,000; total 30,000. Using the simple average of the cycles (25 days) on total purchases would give R$ 37,500, because it ignores each product's weight.Exercises1) (FUNDATEC - 2018 - Santa Rosa City Hall - RS - Tax Auditor) To answer this question, consider the amounts in the table below.Net Working Capital is equal to:A) R$ 500.00.B) R$ 3,000.00.C) R$ 3,500.00.D) R$ 4,500.00.E) R$ 5,500.00.2) (IBADE - 2018 - Vilhena City Council - RO - Financial Analyst - Administration) Working capital management includes current assets and current liabilities. Which of the following is considered a current liability?A) trade notes payable.B) marketable securities.C) inventories.D) trade notes receivable.E) financial investments.3) (Quadrix - 2018 - CREF - 13th Region (BA-SE) - Administrative Assistant) Regarding financial management, judge the following item. Suppose a company has non-current assets of R$ 230 million, non-current liabilities of R$ 170 million and equity of R$ 150 million. In this case, the company's working capital is R$ 90 million.A) TrueB) False4) (VUNESP - 2019 - MPE-SP - Technical Scientific Analyst - Accountant) Regarding decisions on working capital planning and management, it is correct to state:A) working capital decisions are related to financing an entity's operating cycle.B) they are not relevant compared with decisions on the purchase of machinery and equipment.C) they do not involve customer collection periods.D) all other variables held constant, the length of the operating cycle has no relation to the entity's results or to the working capital required.E) all other variables held constant, the longer the operating cycle, the smaller the amount of working capital required.5) (CEPS-UFPA - 2023 - UFPA - Accounting Technician) A certain public entity, in 2022, collected R$ 100,000.00 in taxes and bought a vehicle in cash for R$ 45,000.00 to use in its operating activities. It also took out a credit operation of R$ 20,000.00 and paid the payroll of R$ 60,000.00. These events were provided for in the Annual Budget Law (LOA, Lei Orçamentária Anual). Considering only these events, choose the correct alternative about the Cash Flow Statement (DFC) applied to the public sector, according to the guidance in the MCASP (2021, the Brazilian Public Sector Accounting Manual).A) net cash flow from investing activities is R$ 20,000.00.B) net cash generated in the period was R$ 15,000.00.C) net cash flow from operating activities is R$ 100,000.00.D) net cash generated in the period was (R$ 25,000.00).E) net cash flow from financing activities (R$ 25,000.00).Answers1) B — current assets = cash 1,000 + bank 2,000 + inventories 3,000 + trade receivables 3,500 = 9,500; current liabilities = salaries 1,500 + suppliers 4,500 + discounted trade notes 500 = 6,500; NWC = 9,500 − 6,500 = 3,000. (If the discounted notes are treated as a deduction from trade receivables, the result is the same: 9,000 − 6,000 = 3,000.)2) A3) A — NWC = (equity + non-current liabilities) − non-current assets = (150 + 170) − 230 = 90 million.4) A5) B — operating: 100,000 − 60,000 = 40,000; investing: −45,000; financing: +20,000; net cash generated = 40,000 − 45,000 + 20,000 = 15,000.
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