3.7 Working Capital Ratio

Working Capital is defined as Current Assets minus Current Liabilities net of financing and tax related activities.  This leads to eliminating items such as short term debt and the current portion of long term debt as well as deferred tax assets/liabilities.  The problem group is cash and marketable securities.  The last group is usually split between the financing and investment decisions, but predominately is influenced by the financing decision.   As a result, the usual simplifying assumption is to eliminate cash and marketable securities from working capital.  With these eliminations it largely consists of:  Accounts Receivable, Inventory and Accounts Payable.  These major components lead to the three major turnover ratios.  The numerator of these turnover ratios is usually defined relative to their closest driver.  For example, Accounts Receivable is driven by Sales on Account and therefore Net Credit Sales is used in the numerator if available otherwise Sales.  However, under historical cost accounting Inventory as measured on the balance sheet is more closely aligned with the Cost of Goods Sold (COGS) for an external analyst.  Finally, Accounts Payable is driven by Purchases and so either Purchases if available or COGS is used in the numerator for this ratio.  Formally, we can define them as follows:

In addition, turnover ratios are often expressed in terms of number of days by dividing by the turnover ratio by 365:

Finally, the Cash Conversion cycle is then the aggregate number of days for collecting accounts receivable plus the number of days required to sell inventory  minus the days to pay creditors.

When comparing across firms in some industry the extension of liberal credit may be an important part of the firm’s business strategy.  For example, for Wal-Mart to successfully implement their business model they have to excel along the Process dimension of a balanced scorecard.  This is discussed further in the following example.

As a final remark, note that when valuing a firm, changes in working capital may be a significant source of funds but this can only last for a limited period of time.  Ultimately, change in working capital has to settle down, you should be careful to ensure that the change in working capital is not a significant source of funds in perpetuity!

Tutor Reconciliation:  Proctor and Gamble (PG)

Our objective is to reconcile the following from the 10-K:

Step 1:  Bring up the Income Statement and Balance Sheet for Proctor and Gamble as described in section 3.3.  This is displayed at the bottom of the screen as follows:

The above items deal mainly with the income statement apart from the number of shares outstanding for expressing on a per share basis.

You can stretch across a little the column 1 as displayed above to make the labels more easily displayed and read. 

For Proctor and Gamble you can see the “Cost of products sold” ($37,919) as P&G describe it and Net Sales are $78,938.

Similarly, total Inventories $6,384 and scrolling down reveals the working capital items on the Balance Sheet.

Step 2:  Click on Calculate and we can verify the input and derived fields for the following:

Total Asset Turnover = 0.6159

Working Capital per Share (CA – CL) = -1.9342 per share

Working Capital Turnover (Sales/WC) = -14.3524 per share

Inventory Turnover (COGS/Inventory) = 5.94

Receivables Turnover = 14.80

Payables Turnover = 2.55

Days to Sell Inventory = 61.45

Days to Collect Receivables = 24.67

Days to Pay Payables = 69.80

Cash Conversion Cycle = 16.32

In step 1 we extracted the relevant aggregate numbers from the 10-K and so the full reconciliation can now be traced through as follows.  The first item below being Cash and cash equivalents $2,879.