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What is Working Capital?
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[1]. What is Working Capital?

Working capital is a metric to measure the ability of a business to repay short term obligations, i.e. whether the business has sufficient liquidity to call when it is needed. In formula form:

 Working Capital = Current Assets – Current Liabilities

Although working capital is related to the Balance Sheet, we are discussing this in this cash flow chapter as working capital is related more to liquidity, i.e. cash.

The three main components of working capital are Trade Payables, Inventories, and Trade Receivables.

Let’s start with Trade Payables. As can be seen from the table, an increase in Trade Payables is positive for operating cash flow while a decrease in Trade Payables is negative for operating cash flow. Why?

Trade Payables exist due to a company purchasing either a raw material or service from a supplier and has yet to make payment for it. Thus, goods and services have been received, but pending payment. This means that the suppliers are actually giving a “trade financing” to the company. If Trade Payables increase, this means that the company is actually getting more “trade financing” from suppliers, and thus it is as good as receiving more “cash” to run the business.

On the reverse side of it, if Trade payables decrease, this means the company has paid some of its outstanding debts to suppliers, which reduces the operating cash position of the company.

Moving on to Inventories; goods purchased from Trade Payables will become inventories of the company. Inventories have a holding cost, meaning to say that by holding the inventories, a portion of the company’s cash is tied up with the inventories. Cash can only be realised when the inventories are sold. Thus, an increase in inventories will “decrease” the operating cash flow.

On the flip side of it, decrease in inventories means a part of the cash has been freed up, and thus is positive for operating cash flow.

Increase in Trade Receivables has a negative impact on the operating cash flow, considering that while the company has sold the goods to the client, it has not received payment from the client. Thus, a portion of the company’s cash is tied up with the client. When Trade Receivables increase, it means that more cash is being tied up with clients, and thus the negative impact on the operating cash flow.

When Trade Receivables decrease, it means some of the debts have been collected from the debtors, and thus improved the cash from operations.

Back to TexCycle’s case study, after taking into consideration the movement in working capital, for the financial year 2016, TexCycle’s business operations generated net cash inflow amounting to RM8,626,291, which is higher than 2015’s RM7,357,289.

It is very difficult to find companies that have their operating cash flow increasing every year. Personally, my target is not to find companies with consistent growth in operating cash flow (though it will be great to find one), but to find companies with consistent positive operating cash flow and a growth trend (as opposed to consistent growth) on its operating cash flow.

Next week, we will take a look at what is Cash Flow from Investing Activities and the concept of Free Cash Flow.

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