Working capital is an essential concept in the financial management of any company. It refers to the resources available to cover daily operations and ensure business continuity. Its proper management directly impacts liquidity, solvency, and an organization’s growth capacity. Throughout this #SilverTalk, we will explore the concept of working capital, its application, and its relevance along with the financial metrics that affect it.
Concept and Application of Working Capital
Working capital is defined as the difference between a company’s current assets and current liabilities. Mathematically, it is expressed as follows:
Net Working Capital = Current Assets – Current Liabilities
Current assets include cash, accounts receivable, and inventory, while current liabilities include accounts payable and other short-term obligations. A positive working capital indicates that the company has enough resources to cover its immediate obligations. Its practical application lies in the efficient management of financial resources, ensuring sufficient liquidity to cover short-term commitments without affecting operations.
However, to evaluate a company’s operational health, the amount alone is not enough; the speed at which assets circulate also matters. That’s why net working capital is closely tied to financial indicators that reflect the company’s operational efficiency:
Days Sales Outstanding (DSO): It reflects the average time the company takes to collect its invoices after issuance. It is calculated using the following formula:
DSO = (accounts receivable / total sales) × 360
This indicator is crucial to assess the efficiency of a company’s collection process. A prolonged period may indicate liquidity problems if customers take too long to pay, which may create the need for external financing to cover operating costs. On the other hand, a period that is too short could mean that the company is not offering competitive credit terms, which might affect its ability to attract and retain customers. To reduce DSO, companies can implement strategies such as offering early payment discounts, improving the billing process, proactively following up on overdue accounts, and establishing stricter credit terms.
Days Payable Outstanding (DPO): It shows how long the company takes to pay its suppliers. It is calculated as follows:
DPO = (accounts payable / cost of sales) × 360
This indicator is essential as it reflects how efficiently a company manages its obligations to suppliers. Longer terms can improve working capital by allowing the company to retain liquidity longer before making payments. However, extending the payment period too much may create distrust among suppliers and harm the business relationship, which could lead to less favorable credit terms or even supply interruptions. Companies can optimize accounts payable management by negotiating favorable payment terms, aligning payment due dates with the revenue cycle, and avoiding delays that generate penalties or late fees.
Days Inventory Outstanding (DIO): It represents the time it takes the company to sell its inventory and convert it into revenue. It is calculated as follows:
DIO = (inventory / cost of sales) × 360
Excess inventory can tie up capital, increase storage and obsolescence costs, and affect profitability. On the other hand, insufficient inventory can result in lost sales and delay the company’s ability to meet market demand. The key lies in maintaining adequate levels to ensure operations and optimize liquidity.
Cash Conversion Cycle (CCC): Combines the three previous indicators and measures the time it takes a company to turn its investments back into cash. It is calculated as follows:
CCC = DIO + DSO – DPO
This cycle is a dynamic measure of working capital, helping us understand how operational decisions directly impact cash flow. A shorter cash conversion cycle means the company recovers its investment in inventory faster, improving liquidity and operational capacity. If the cycle is long, it may mean the company is taking too long to turn its investment into cash, potentially leading to cash flow problems. Optimizing the cash conversion cycle can improve profitability without requiring additional debt, enabling sustainable growth.
Examples by Industry Type
To better understand the importance of working capital, let’s consider the following examples across different industries:
Construction and/or High-Value Manufacturing Industry (automotive, tech):
Since production cycles can be long and require costly materials, these companies carefully manage inventory and accounts payable to avoid supply chain interruptions and preserve liquidity. In this case, maintaining positive working capital is ideal due to irregular cash flows or long production cycles.
For example, a tech company that manufactures medical equipment invests millions in imported components before completing a single product. To avoid interruptions due to a lack of liquidity, it negotiates 60 to 90-day payment terms with suppliers while maintaining phased inventory levels per project stage. It also invoices by project milestones to advance part of the collections. In this case, positive working capital helps sustain production even when income is delayed.
Retail Industry (fuel, supermarkets, department stores)
These businesses handle large inventory volumes with relatively low profit margins. Their working capital strategy focuses on optimizing the cash conversion cycle by reducing inventory days and accelerating receivables, while negotiating extended payment terms with suppliers.
This allows them to operate with low working capital without compromising profitability. In the case of fuel distribution companies, they often operate with negative working capital, a strategy considered normal within the industry.
For example, a wholesale fuel distributor sells large volumes of gasoline and diesel daily to gas stations and corporate clients. Most of these sales are paid in cash or by credit card, while supply contracts with refineries allow payment terms of up to 15 or 30 days. This structure enables them to operate with negative working capital, as cash enters before payments to suppliers are due. Additionally, with fast inventory turnover (fuel is sold almost as soon as it arrives), the number of inventory days remains low, reducing capital tied up in current assets. This business model relies on a very short cash conversion cycle that optimizes cash flow and allows operations to be financed without short-term loans. It is a clear example of how negative working capital can be healthy and strategic when supported by favorable operational and contractual conditions.
Conclusion
In summary, working capital is more than just an accounting figure: it’s a dynamic reflection of a company’s ability to operate, grow, and create value. That’s why the financial indicators associated with its management allow for early detection of inefficiencies and support strategic, data-driven decisions. Understanding how to manage working capital appropriately based on the industry allows for strategic decisions that optimize resources and ensure sustainable business growth. In the end, good working capital management is not only key for smooth and profitable operations but also strengthens the company’s competitive position in the market.