What is Working Capital Requirement?
The Working Capital Requirement (WCR) quantifies the estimated funding needed by a company to sustain its operations and retain business continuity.
Conceptually, the working capital requirement (WCR) is the funds—or cash on hand—required by a business to fulfill its near-term liquidity and continue operating.
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How to Calculate Working Capital Requirement (WCR)
The working capital requirement reflects a company’s minimum cash balance that must be maintained to meet its short-term obligations coming due within twelve months (<12 months) and is thereby deemed a measure of liquidity risk.
The working capital metric consists of current assets and current liabilities, with each section recorded on the balance sheet, one of the core three financial statements.
The balance sheet—or statement of financial position—provides a “snapshot” of the company’s current financial position, including its total assets, liabilities, and shareholders’ equity.
In practice, the working capital requirement measures the operational efficiency at which a company is run by management, with regard to internal decisions that pertain to cash collection policies, credit policies, and payment terms with 3rd party suppliers and vendors.
On the subject of liquidity, an asset is deemed “liquid” if capable of being sold in the open markets relatively quickly without the necessity of trimming the sale price by a steep discount.
In short, analyzing a company’s working capital requirement is a practical method to comprehend and set a pin on the minimum cash balance (i.e. the required cash on hand) to ensure the risk of default and insolvency is kept to a minimum.
Furthermore, the working capital requirement, often referred to as the “working capital peg” in the context of mergers and acquisitions (M&A), is one of the determinants of the purchase price, as the company must be capable of operating post-closing of the transaction to ensure a smooth hand-off.
By subtracting operating current liabilities from operating current assets, the resulting figure reflects the working capital requirement (WCR) concept, and provides unique insights into a company’s ability to cover its short-term obligations and mitigate liquidity risk.
- Step 1 ➝ Calculate Operating Current Assets (Accounts Receivables, Inventory)
- Step 2 ➝ Calculate Operating Current Liabilities (Accounts Payable, Accrued Expense)
- Step 3 ➝ Subtract Operating Current Liabilities from Operating Current Assets
Working Capital Requirement Formula (WCR)
The formula to calculate working capital requirement (WCR) deducts current liabilities from current assets.
Given the working capital requirement (WCR), a company can apply the insights derived to improve upon its liquidity position and necessity for cash to fund day to day operations, starting with setting a minimum cash balance to maintain.
The historical trends in a company’s WCR ratio to the present date can provide valuable insights into a company’s financial management practices.
But since the working capital requirement (WCR) is expressed as a gross metric, the value must be standardized for the metric to be suitable to analyze the historical patterns and for comparative analysis to peer companies.
Where:
- Change in NWC = Change in Net Working Capital (NWC) = Beginning NWC – Ending NWC
- Net Revenue = Gross Revenue – Returns – Discounts – Sales Allowances
Given a negative change in net working capital (NWC), that implies more free cash flow (FCF), and vice versa.
On the other hand, a positive change in NWC implies less free cash flow (FCF), since more cash is tied up in the company’s day to day operations.
How Does Seasonality Impact Working Capital
While the variance is contingent on the industry, the trends in working capital tends to fluctuate substantially for certain sectors. For instance, the retail industry is cyclical in particular, where inventory cycles out much quicker around the holidays, but accumulates afterward (i.e. non-holiday periods).
Therefore, the approximate working capital requirement should be set based on a rolling twelve month basis to ensure at least one entire cycle is captured, wherein the effects of seasonality are normalized (“spread across”).
However, the discrepancies around the total amount of cash and cash equivalents deemed non-discretionary (or “working capital peg”) in M&A reflects how estimated the required cash on hand is easier said than done.
In fact, the inclusion of conditional provisions that grant one party to be compensated based on meeting a condition is common in M&A transactions.
Why? Cash and cash equivalents do not directly contribute toward the generation of revenue, while debt and debt-like securities are a source of financing (and thus, non-operational).
Hypothetically, a company with high credit risk could raise a significant amount of cash via debt financing, creating the misleading visual that its current liquidity position is in good standing.
The intuition behind the usage of “operating” current assets and “operating” current liabilities is that cash and cash equivalents are not directly tied to the operating activities of a company.
On the other hand, debt and interest-bearing securities (i.e. debt-like instruments) are sources of funds, alike financing activities, rather than an operating activity.
Therefore, a company’s operating performance of a company, including its liquidity risk, should be computed and tracked across historical periods, with cash and debt excluded.
What is a Good WCR Ratio?
The standard benchmark for the working capital requirement (WCR) is different per industry, given the differentiating factors, namely around each company’s respective business model, namely its revenue model (i.e. how sales are generated) and its cost structure (i.e. fixed costs vs. variable costs), among others.
- High WCR Ratio ➝ Generally, a positive working capital is perceived by most public equity and private investors as an indicator that a company has sufficient cash on hand to fulfill its short-term liabilities.
- Negative WCR Ratio ➝ In contrast, a negative working capital occurs from the value of a company’s current liabilities exceeding that of its current assets.
One nuance to the statement that a negative working capital implies the company is at risk of default from the mismanagement of funds is if its days payable outstanding (DPO) is outsized.
For example, a negative working capital balance could stem from an efficient credit collection process and quick inventory turnover, coupled with favorable payment terms with suppliers and vendors.
Given that hypothetical scenario, the company likely has a low accounts receivable (A/R) and inventory balance, while accounts payable (A/P) is very high, in excess of the combined carrying value of the two current assets in the formula (and thereby causing working capital to dip below zero).
The prolonged days payables outstanding (DPO) offsets the efficiency in collecting receivables and cycling through inventory. However, that does not mean the company’s operational performance is inefficient, but rather, that there is a clear area of improvement in the business model.
With that said, companies should have an economic incentive to improve its WCR, or else excess funds tied up in working capital, which could be utilized more efficiently elsewhere in the business. On the other hand, a low WCR may indicate a risk of liquidity issues or difficulties in meeting short-term obligations.
The fluctuations in working capital requirement (WCR) can offer practical insights into a company’s operational efficiency and financial condition, with the historical data to support that statement.
By monitoring changes in WCR over time, businesses can identify trends, anticipate cash flow challenges, and make informed decisions to improve liquidity management.
Working Capital Requirement Calculation Example (WCR)
Suppose we’re tasked with calculating the working capital requirement (WCR) of a retail company that recently reported its annual report (10-K) for the fiscal year ending 2024.
The balance sheet of our hypothetical retail company is illustrated in the table below:
Balance Sheet | 2024E |
---|---|
Assets | |
Cash and Cash Equivalents | $150,000 |
Accounts Receivable (A/R) | $200,000 |
Inventory | $300,000 |
Prepaid Expenses | $50,000 |
Total Current Assets | $700,000 |
Property, Plant, and Equipment (PP&E) | $500,000 |
Total Assets | $1,200,000 |
Liabilities | |
Accounts Payable (A/P) | $80,000 |
Short-Term Debt | $100,000 |
Accrued Expenses | $20,000 |
Total Current Liabilities | $200,000 |
Long-Term Debt (LTD) | $400,000 |
Total Liabilities | $600,000 |
Shareholders’ Equity | |
Common Stock and APIC | $200,000 |
Retained Earnings | $400,000 |
Total Shareholders’ Equity | $600,000 |
Total Liabilities and Equity | $1,200,000 |
Of the company’s $1.2 million in total assets, $700,000 is recorded in the current assets section.
On the other hand, the company recorded $600,000 in total liabilities, with $200,000 recognized as current liabilities.
The current ratio, which compares a company’s total current assets to current liabilities, is 3.5x, reflecting a strong liquidity position.
Since the objective here is to measure a company’s operational performance (and liquidity risk), the cash and cash equivalents balance of $150,000 and short-term debt of $100,000 will be deducted.
- Operating Current Assets = $700,000 – $150,000 = $550,000
- Operating Current Liabilities = $200,000 – $100,000 = $100,000
Therefore, the working capital requirement (WCR) is $450k, reflecting the minimum cash balance that the company must maintain to ensure operation continue to run smoothly without encountering any liquidity issues.
- Working Capital Requirement (WCR) = $550,000 – $100,000 = $450,000
In closing, the $450k working capital requirement (WCR) must be confirmed with historical periods to ensure the implied minimum cash balance reflect normalized operations, not an anomaly.
If the WCR ratio is indeed affirmed to be consistent with the past, that supports the notion that a cash balance of $450k is a reasonable target to set to meet its short-term obligations, ensuring the sustainability of its operations.