Introduction
In June 2021, the British clothing retailer, Next plc published its yearly accounts. The statement of financial position indicates that the company had the working capital (current assets less current liabilities) of £1.09bn, as of January 2021. Sagner (2014) describes working capital as [1]:
'the arithmetic difference between two balance sheet aggregated accounts: current assets and current liabilities.'
Working capital management is a critical function of any finance and business manager and an essential part of the business's short term-planning [2]. Every organisation requires cash and other assets that can be converted quickly into cash to fund their day-to-day operations, e.g., to pay wages and suppliers. McLaney and Atrill (2018) identify key components of working capital as follows [3]:
Current assets:
· Inventory, which may include raw materials, work-in-progress or finished goods. The composition and the amount of inventory will significantly vary between different companies across various industries. For example, Next plc held almost £537m worth of inventory. While for many service businesses, inventory may be non-existent.
· Trade receivables relate to credit sales where a customer is expected to pay for goods or services received by a specified future date. Trade receivables are essential in ensuring a firm’s liquidity. If customers take too long to pay, the company may struggle to find the cash to settle its day-to-day operational expenses, such as employee salaries and wages.
· Cash (in hand and at a bank) is generally used to meet current debts as they fall due. It may include paying the suppliers or, again, the workforce.
Current liabilities:
· trade payables represent the amount owed to creditors for purchases. Many businesses will buy raw materials or finished goods on credit and pay the amount owed at an agreed future date.
· banks overdrafts are an effective method of meeting a business’ short-term liabilities if there is an insufficient amount of cash at a bank or other current assets that could be converted into cash. This may happen, for example, if a business takes too long to recover money from customers.
In essence, the aim of working capital management is to balance the objectives of liquidity and profitability. A company with a substantial amount of cash and inventory will show a remarkable ability to pay its debts as and when they fall due for payment. However, this unnecessarily high level of liquid assets may, in turn, affect profitability because the company has funds tied up in idle assets. In such a case, the excess of funds cannot be invested in other assets or business opportunities to generate additional revenue. PwC UK Working Capital Report 2019/20 found that a number of global listed companies had excess working capital of €1.2tr on balance sheets [4]. This analysis used data available from 13,328 companies listed on various stock exchanges globally. As a result, a business will seek to invest a minimum amount of funds in working capital to ensure the company can meet the clients' demand for products or services and pay any short-term debts and liabilities. Any surplus cash will usually be invested in other assets to increase profitability. Moreover, there are significant costs associated with holding inventory, including storage or handling, the costs of financing inventory, or the opportunity cost [3]. That is another reason why a company will seek to minimise its inventory levels.
Accounting ratios
Some fundamental accounting ratios may be a helpful tool in assessing a company’s overall working capital position. Each ratio may have a different interpretation depending on the type of business and the sector involved. Therefore, we will apply ratios to analyse two similar businesses: Next and New Look – globally operating British fashion retailers.
Current ratio
This ratio indicates if a business has enough current assets to pay off the current liabilities as and when they fall due.
Quick test (acid ratio)
This ratio is a more rigid version of the current ratio where inventories are subtracted from the current assets. McLaney and Atrill (2018) describe it as a more stringent test of liquidity as many businesses may not be able to turn their inventories into cash as quickly as possible to meet their debts. In other words, the acid ratio indicates if a company can cover its immediate liabilities without selling inventory.
Inventory turnover
This ratio suggests how many times inventory was turned over during the period in question. Generally, a higher inventory turnover ratio indicates a company has efficient inventory management, while a lower ratio may be a sign of the company’s excessive inventory in relation to sales volume.
Inventory days
Inventory days ratio is a basic method to calculate the average period a company holds its inventory before it is sold to the customers. The period can be represented in days (multiplied by 365), weeks (multiplied by 52), or months (multiplied by 12).
Debtor days
This ratio indicates the length of time, on average, that customers or debtors take to pay the amounts they owe to a business. The longer the period, the longer it takes for a company to recover its outstanding customer invoices resulting in a longer cash operating cycle and potentially decreasing liquidity.
Creditors days
This ratio measures how long a business, on average, takes to pay off its outstanding debts. Generally, a firm will seek to increase the average time to settle its liabilities. This practice will help to lower the investment in working capital and shorten the working capital cycle.
If the value of credit purchases is unavailable, the cost of sales may be used as a surrogate figure.
Working capital turnover
This ratio analyses the relationship between the money used to fund short-term operations and the sales generated from these operations [3].
It is vital to remember that any financial analysis should be evaluated against an appropriate benchmark. In this case, we have compared two competing companies from the same industry by obtaining the information from their most recent financial accounts. Figures highlighted in green indicate more favourable results against the other. Next (NXT) has an impressive current ratio of 1.91:1 compared with 0.66:1 for New Look (NL). The ratios smaller than 1:1 indicate that the company has more current liabilities than current assets. While many businesses can operate successfully with a ratio of 1:1 or smaller, the NL liquidity may soon become a matter of concern.
A more stringent version of the current ratio, a quick test that does not include the value of inventories, suggests that NXT should still be in a great position to meet its current liabilities as and when they fall due. On the other hand, NL does not show its ability to meet short-term liabilities, potentially leaving financial analysts and other stakeholders concerned about the NL liquidity. Another interesting finding was the length of time that, on average, debtors take to pay the amounts they owe to a business. In the case of NL, it was only 15.7 days, caused by the fact that the company had only about £41.8m in trade receivables. This is a relatively small amount accounting only for 18.5% of their total current assets.
In contrast, the value of NXT trade receivables is over £1.1bn, which accounts for 48.4% - almost half of the total value of current assets. In principle, the high value of trade receivables might imply that a company does not efficiently recover its funds from other parties. Trade payables and receivables management, however, are highly affected by trade agreements a company has in place with its clients and depends on various factors. Therefore, it would be short-sighted to purely form a judgment on the company’s efficiency to recover its funds based on one particular ratio. We shall discuss trade payables and receivables management in future articles.
PwC Working Capital Report 2019/20
To consolidate the knowledge learnt in this article, we highly recommend reading the report produced by PwC UK on working capital. The study was based on over 13,000 globally listed companies, with the data taken for the period between 2014 and 2018. The authors claim that working capital is the next value driver and that addressing excess working capital could increase the return on invested capital by up to 30 basis points (0.30%). This report's fundamental measure of value creation is the return on invested capital or ROIC, which is calculated by dividing the net operating profit after tax with the consolidated sum of equity and debt.
ROIC = Net operating profit after tax / (debt + equity)
The report found that companies managed to improve their returns as measured by ROIC by closely managing EBIT (earnings before interest and taxation). However, the overall growth was offset by a stalling net working capital performance, disrupting the improvement in ROIC.
The full report (Working Capital Report 2019/20: Creating value through working capital) can be accessed via this link: https://www.pwc.com/gx/en/working-capital-management-services/assets/working-capital-report-final.pdf
Any thoughts?
This article aimed to explain the basics of working capital management, including the management of inventory or trade payables and receivables. Working capital is the cash tied up in the day-to-day operations of the business. Therefore, the effective management of current assets and liabilities is vital in ensuring a company’s ability to fund everyday operational expenses while allowing the company to invest surplus cash in other investments to secure long-term growth and greater revenue.
References
[1] Sagner, J. (2014). Working Capital Management. 1st edition. Wiley. Available at: https://www.perlego.com/book/1002956/working-capital-management-pdf
[2] McLaney, E. and Atrill, P. (2020) Accounting and Finance: An Introduction. 10th edition. Pearson. Available at: https://www.perlego.com/book/1356521/accounting-and-finance-an-introduction-pdf
[3] Atrill, P. and McLaney, E. (2018) Management Accounting for Decision Makers 9th edition. 9th edition. Pearson. Available at: https://www.perlego.com/book/810718/management-accounting-for-decision-makers-9th-edition-pdf
[4] Windaus, D., Tebbett, S. (2019). PwC UK. Working Capital Report 2019/20: Creating value through working capital [online]. Available at https://www.pwc.com/gx/en/working-capital-management-services/assets/working-capital-report-final.pdf