Working capital

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Domestic credit to private sector in 2005

Working capital (abbreviated WC) is a financial metric which represents operating liquidity
available to a business, organization, or other entity, including governtal entity. Along with fixed
assets such as plant and equipment, working capital is considered a part of operating capital. It is
calculated as current assets minus current liabilities. If current assets are less than current
liabilities, an entity has a working capital deficiency, also called a working capital deficit. Net
working capital is working capital minus cash (which is a current asset) and minus interest
bearing liabilities (i.e. short term debt). It is a derivation of working capital, that is commonly
used in valuation techniques such as DCFs (Discounted cash flows).

Working Capital = Current Assets − Current Liabilities

A company can be endowed with assets and profitability but short of liquidity if its assets cannot
readily be converted into cash. Positive working capital is required to ensure that a firm is able to
continue its operations and that it has sufficient funds to satisfy both maturing short-term debt
and upcoming operational expenses. The management of working capital involves managing
inventories, accounts receivable and payable and cash.

Current assets and current liabilities include three accounts which are of special importance.
These accounts represent the areas of the business where managers have the most direct impact:

 accounts receivable (current asset)

 inventory (current assets), and
 accounts payable (current liability)

The current portion of debt (payable within 12 months) is critical, because it represents a short-
term claim to current assets and is often secured by long term assets. Common types of short-
term debt are bank loans and lines of credit.

An increase in working capital indicates that the business has either increased current assets (that
is has increased its receivables, or other current assets) or has decreased current liabilities, for
example has paid off some short-term creditors.
Implications on M&A: The common commercial definition of working capital for the purpose
of a working capital adjustment in an M&A transaction (i.e. for a working capital adjustment
mechanism in a sale and purchase agreement) is equal to:

Current Assets – Current Liabilities excluding deferred tax assets/liabilities, excess cash,
surplus assets and/or deposit balances.

Cash balance items often attract a one-for-one purchase price adjustment.

Working capital management

Corporate finance

Working capital

Cash conversion cycle

Return on capital
Economic value added
Just in time
Economic order quantity
Discounts and allowances
Factoring (finance)

Capital budgeting

Capital investment decisions

The investment decision
The financing decision

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Decisions relating to working capital and short term financing are referred to as working capital
management. These involve managing the relationship between a firm's short-term assets and its
short-term liabilities. The goal of working capital management is to ensure that the firm is able to
continue its operations and that it has sufficient cash flow to satisfy both maturing short-term
debt and upcoming operational expenses.

Decision criteria

By definition, working capital management entails short term decisions - generally, relating to
the next one year period - which are "reversible". These decisions are therefore not taken on the
same basis as Capital Investment Decisions (NPV or related, as above) rather they will be based
on cash flows and / or profitability.

 One measure of cash flow is provided by the cash conversion cycle - the net number of
days from the outlay of cash for raw material to receiving payment from the customer. As
a management tool, this metric makes explicit the inter-relatedness of decisions relating
to inventories, accounts receivable and payable, and cash. Because this number
effectively corresponds to the time that the firm's cash is tied up in operations and
unavailable for other activities, management generally aims at a low net count.

 In this context, the most useful measure of profitability is Return on capital (ROC). The
result is shown as a percentage, determined by dividing relevant income for the 12
months by capital employed; Return on equity (ROE) shows this result for the firm's
shareholders. Firm value is enhanced when, and if, the return on capital, which results
from working capital management, exceeds the cost of capital, which results from capital
investment decisions as above. ROC measures are therefore useful as a management tool,
in that they link short-term policy with long-term decision making. See Economic value
added (EVA).

[edit] Management of working capital

Guided by the above criteria, management will use a combination of policies and techniques for
the management of working capital. These policies aim at managing the current assets (generally
cash and cash equivalents, inventories and debtors) and the short term financing, such that cash
flows and returns are acceptable.

 Cash management. Identify the cash balance which allows for the business to meet day
to day expenses, but reduces cash holding costs.
 Inventory management. Identify the level of inventory which allows for uninterrupted
production but reduces the investment in raw materials - and minimizes reordering costs -
and hence increases cash flow. Besides this, the lead times in production should be
lowered to reduce Work in Progress (WIP) and similarly, the Finished Goods should be
kept on as low level as possible to avoid over production - see Supply chain management;
Just In Time (JIT); Economic order quantity (EOQ); Economic production quantity
 Debtors management. Identify the appropriate credit policy, i.e. credit terms which will
attract customers, such that any impact on cash flows and the cash conversion cycle will
be offset by increased revenue and hence Return on Capital (or vice versa); see Discounts
and allowances.
 Short term financing. Identify the appropriate source of financing, given the cash
conversion cycle: the inventory is ideally financed by credit granted by the supplier;
however, it may be necessary to utilize a bank loan (or overdraft), or to "convert debtors
to cash" through "factoring".

Working Capital Management

Working Capital is the money used to make goods and attract sales. The less Working Capital
used to attract sales, the higher is likely to be the return on investment. Working Capital
management is about the commercial and financial aspects of Inventory, credit, purchasing,
marketing, and royalty and investment policy. The higher the profit margin, the lower is likely to
be the level of Working Capital tied up in creating and selling titles. The faster that we create and
sell the books the higher is likely to be the return on investment. Thus when we have been using
the word investment in the chapter on pricing, we have been discussing Working Capital.

In the earlier chapter on Accounting concepts we showed a sample Balance Sheet. The Balance
Sheet comprises Long term Assets (real estate, motor vehicles, machinery) and Net Current
Assets. The word Working Capital is often used for Net Current Assets. In this chapter we will
exclude Cash in Bank from our definition. Thus our Balance Sheet appears as follows:

Long Term Assets  6,000 

Working Capital  28,000 
Cash in Bank  1,000 
Total Capital  35,000 

We defined Net Current Assets as Total Current Assets less Total Current Liabilities. In this
book we shall subtract current liabilities items from current assets as follows:

Young 
Inventory  15,000 
Receivables  17,000 
Prepayments  6,000 
Payables  (9,000) 
Customer Prepayments  (1,000) 
Working Capital  28,000 

Using this format we can state than any reduction in the Working Capital figure, other than for
provisions for write-offs and write-downs, will generate the same amount of cash. Thus if a
customer pays US$ 500 that he owes to the organisation, the Working Capital figure will fall be
US$ 500, and the cash figure will be increased by the same figure. This revised format is useful
when designing spreadsheet financial planning models for business plans or for internal
reporting.

The Working Capital cycle, or Cash Conversion cycle as it is also called is usually expressed in
terms of the number of days. This figure is the average time that it takes to turn investment in
books into cash and profit. We studied Payback in the previous chapter. Payback expresses the
number of days required to recoup the original investment on a single title. In the organisation’s
Balance Sheet there will be the costs of paper, titles still under development, author advances of
books already and not yet published. In addition there will be the cost of stocks of unsold books,
Accounts Receivable, and Accounts Payable.

Example: Osiris publishers

In order to illustrate the concept I have adapted slightly the example used in the chapter on
Accounting concepts. The Young scenario has the same Income Statement but I have adapted
the Prepayments figure within the Balance Sheet in order to illustrate more elements of

Working Capital. I have divided the Prepayments figure of 6,000 into Prepayments to authors
and Prepayments to printers. The totals are the same.

Income Statement  Osiris 

Turnover  100,000 
Cost of Sales  (57,000) 
Royalties  (18,000) 
Gross Profit  25,000 
 Distribution costs  (5,000) 
Promotion  (2,000) 
Write-offs  (3,000) 
Administration costs  (10,000) 
Operating Profit  5,000 
Analysis 
Balance Sheet  Osiris  Working Capital / Sales 28.00% 
% 
Inventory  15,000  Inventory in days  96 
Receivables  17,000  Receivables in days  62 
Prepayments: authors  3,000  Prepayments in days: 61 
authors 
Prepayments : printers  3,000  Prepayments in days : 19 
printers 
Payables  (9,000)  Payables  (36) 
Customer Prepayments  (1,000)  Customer Prepayments  (4) 
Working Capital  28,000  Working Capital Cycle in 198 
days 

Explanation of the calculations

Working Capital figure Explanation 

Inventory in days  (Inventory / Cost of Sales) x 365 = 96 days. More correctly
the purchases figure, if available should be used, in this
case excluding royalties. Thus the publisher holds
approximately 2 months of unsold inventory
Accounts receivable in days  (Receivables / Turnover) x 365 = 62 days. Assuming the
turnover is phased evenly throughout the year, this means
the on average customers take 62 days to pay
Prepayments in days – (Prepayment: authors / Royalties) x 365 = 61 days. In
authors  practice royalties will be earned that reduce this figure
while new advances are also paid to other authors.
Prepayments in days – (Prepayment: printers / Cost of sales) x 365 = 19 days. In
printers  practice part of the Cost of Sales figure would be new title
pre-press costs not carried out at the printer. This item
relates to cases where advance payments are made to
printers as a deposit or for paper. The purchases figure if
available would give a more accurate figure.
Accounts Payable in days  (Payables /(All purchases) x 365

(9,000 / (57,000 + 18,000 + 5,000 + 2,000 + 10,000) x 365

= 36 days

The purchases (investment) rather than the cost of sales

figure should be used if available. I have assumed that this
figure includes money owed to authors (see prepayment:
authors)
 Customer Prepayments  (Customer Prepayments / Turnover) * 365 = 4 days
Working Capital cycle in 96 + 62 + 61 + 19 - 36 - 4 = 198
days 
Working Capital / Sales %  28,000 / 100,000 = 28% 

Explanation of the figures

 On average it takes Osiris 198 days to turn an investment into cash and profit. 
 New tiles will use more Working Capital than reprints
 On average Working Capital equates to 28% of turnover
 The percentage of Working Capital to turnover varies according to the type of publishing
 Trade publishing in developed countries may have a figure of between 35- 45 % of
turnover. Academic publishing is higher. Professional publishing uses a lower Working
Capital % figure
 Working Capital is also a measure of risk

This figure may include new titles, reprints, foreign language coeditions, licence sales. The
figure would be different for each of these. Within the total Balance Sheet, the Working Capital
figure will vary throughout the year according to the phasing of new titles and the sales cycle.
Publishers should know the typical Working Capital cycle and the level of Working Capital as a
% of turnover for each market or distributor, for each category of book.

The relevance of Working Capital to publishing in young economies

In the FSU Working Capital levels were controlled at government rather than factory level.
Invoices were settled on standard credit terms. Non or slow payment was not a major problem
for printers and publishers. Risk was a government problem. Authors were paid standard royalty
rates and terms. Inventory levels and print runs were according to a formula: in textbook
publishing, 150% of the textbook requirement would be printed in year 1, the remaining 50%
would be used for replacement copies in subsequent years. Publishers, printers and distributors
would negotiate for annual cash budgets but did not have to concern themselves about Working
Capital questions except where budget moneys were delayed. 

Printing capacity was sufficient to produce local and other agreed requirements. Thus textbook
printing would commence in November for the following September. In a competitive open
economy printers would have to offer discounts and credit to persuade publishers to take the risk
of early ordering. Schools would demand the latest up-to-date editions. Publishers would have to
borrow money from the bank or shareholders to pay for the inventory.

For young economies, the implications are as follows.

1. In young economies the first industries to develop are those with low or negative
Working Capital % to sales. Negative Working Capital is where the organisation uses
 supplier credit or customer Prepayments to fund their day to day needs.
E.G. banks and financial services, retailers, distribution, industries with cash sales or
advance payments on signature of contract (e.g. printers). Organisations with negative
Working Capital use the money from their customers with which to invest and to pay
suppliers.
2. Competition is fiercest among industries with low or negative Working Capital / sales %
figures. Financial entry barriers are lower and these industries are easier to expand.
However profit margins are often lower because of the competition (but not always!) and
the failure rate among such industries among developed countries is usually higher.
3. Banks are attracted to industries with low or negative Working Capital / sales % figures
as cash and profits are earned more quickly
4. Entrepreneurs are attracted to industries with low or negative Working Capital % figures
5. Most marketing innovations in book publishing have come about through the application
of the above Working Capital concepts to creating additional sales and expanding the
market. Most of the innovations introduced at the end of the previous chapter were
created by reduced the level of Working Capital and the time schedule of creating and
selling books.
6. The customers, suppliers and authors of book publishers also want to operate to a low or
negative Working Capital / sales %. Thus printers ask for advance payments e.g. for
paper, distributors will try to withhold payment until they have received money from
their customers.
7. Printers are loath to change from their dominant position where they could dictate prices
and schedules according to price scales formulated at state level. These price scales were
geared to maximum production output, not to satisfying publishers and their customers
under national or international competition. 4-colour printing would cost 4-times the cost
of single colour printing, despite the introduction of modern 4-colour sheet-fed presses.
Printers will change their attitude to pricing and print-runs only in a crisis. In many young
economies printers have not co-operated with publishers (partly the fault of the
publishers) and faced near collapse as publishers have purchased printing overseas.
8. In developed countries publishers have sometimes allowed retail groups extra credit (=
higher Working Capital for publishers) in order to encourage them to expand into new
outlets or sell more books. It is essential to distinguish between genuine expansion cases
and opportunistic entrepreneurs. The more a publisher is actively engaged in marketing
and distribution, the less likely is the publisher to have to rely on offering credit as an
incentive.
9. The concept applies equally to state enterprises and non-profit making organisations. If
cash and profits are generated more quickly, new titles can be commissioned sooner, staff
and suppliers paid promptly. Bank interest is reduced.
10. Where producers are dominant, their customers will have to accept higher levels of
Working Capital. Where customers are dominant, the producers have to accept a greater
burden. In some young economies, the government may have a policy of holding key
organisations in the state sector or as majority owned state enterprises rather than
encouraging a “free-for-all enterprise policy. This may affect printers, publishers and
distributors. This policy will affect the evolution of the Working Capital cycle and may
tilt it more in favour of producers.
Working Capital levels in book publishing in developed countries

Working Capital is a major problem in book publishing. Most publishers solve the question on a
temporary basis by negotiating credit with printers and other suppliers. Their own customers
solve the problem by negotiating credit with publishers or demanding “sale or return” terms.
“Sale or return” terms make planning and cash forecasting much more difficult. Most publishers
rightly prefer to offer a slightly higher discount for a firm sale. Retailers will argue that they
would not purchase many new titles without their risk being mitigated by a “sale-or-return”
policy”

The central issues, which must be solved, are:

 Investment decisions rely too heavily on economies of scale e.g. in printing prices, by
amortising first edition costs against larger print runs
 Publishers produce too many titles, which receive too little promotional effort and thus
sell slowly or not at all.

These can be solved only through long term changes in publishing strategy and greater attention
to the “value chain” where suppliers, publishers, wholesalers and retailers co-operate to mutual
benefit and shared risk. On demand publishing may reduce inventory levels but does not solve
the marketing aspects.

Many publishers have studied the publishing of music CD’s and cassettes, and of greeting cards
with a view to finding solutions. While lessons can be learned, there are major differences:

CD’s, cassettes and greeting cards 

 Are all high margin projects

 Carry much heavier promotion budgets and commitment to marketing
 Are standardised in format
 Enjoy few economies of scale so short run and on-demand manufacture are the norm
 Sell to a more wide variety of retailers
 Sell on a less seasonal basis

Paperback publishers have adopted some of these aspects and have fought successfully to
overcome the low price perception of paperbacks. Paperbacks can now sell in many cases at the
same price as a hardback edition. The creation of “hit-parades” or “Top 10” listings has been
adopted for books of different categories and has attracted significant media attention thus
making books more fashionable. As a result books may sell faster, perhaps at higher prices and
thus reduce Working Capital levels.

“Book Packagers”
Book packagers create books under contract to publishers, bookclubs or foreign distributors.
They evolve as part of the specialisation process especially when publishers become larger and
more bureaucratic. Publishers buy the rights for a territory for a period of years or number of
printings (provided that the title stays in print). The financial attraction to publishers is that they
can buy smaller print runs at economic cost. Most publishers will make advance payments to the
packagers but may be able to approve the content and design. Most packagers prefer to sell
finished books rather than licence titles on a film and royalty basis. 

Packagers buy at low prices from printers because they create only a small number of titles but
each title will have a large print run. Packagers often stay loyal to printers who reward them with
long credit and, in many cases, lower printing prices than those paid by their publisher
customers.

In the TV world many program companies will create programs for several networks while TV
companies concentrate on distributing the programs. The production companies will retain the
rights and earn fees for repeat-shown programs. A similar situation exists in the multimedia field.

Thus packagers are specialists who are not involved in marketing and distribution. Subsequently
a small number of them have decided to become publishers and done so very successfully after
re-financing. Most stay as packagers. Compared with publishers, these packagers have little
market value in acquisition terms.

Thus packagers are very similar to many private publishers in young economies but with
important differences as the table below shows: