Working Capital is an important concept to understand in Financial Modelling, as it can often be the main driver of cash flow for

a company. We are going to run through the three most common components of Working Capital that drive cash flow for a substantial proportion of companies. First, what is working capital? Working Capital is strictly defined as Current Assets - Current Liabilities. However, current assets often includes an amount of cash, and current liabilities often include an amount of short term debt, which are both parts of the capital structure of a company. As such when analysing the Working Capital of a company we adjust Working Capital by subtracting cash from current assets, and subtracting short term debt from current liabilities, to get adjusted Working Capital. Working Capital is basically the capital invested in the company that is "put to work". This is the opposite of fixed capital, which is invested in long-term assets such as buildings that stay in the same form of investment for a long period. The three major components of working capital that show up in a lot of financial statements are: 1. Receivables, 2. Inventory, and 3. Creditors Receivables: Receivables literally means amounts of cash owed to the company in question that have not been received yet. The most common type of receivable for industrial companies is a Trade Receivable, which is created when a company sells a product to a customer and gives them a credit term that means they can delay cash payment. For a company that records 200 in sales in a period, but only collects 140 in cash from sales in that period, the company will record a Trade Receivable for the difference (60), representing the amount owed to it in sales revenue that it did not collect. Inventory: Is a store of the goods that the company intends to sell. Inventory can be in various forms, including Raw Materials, Work in Progress, Finished Goods, or goods in transit. Raw Materials are generally things such as raw steel or iron or another commodity input that the company intends to use to create a good. Work in Progress is generally goods that are in the process of being manufactured for sale (for a company like Ford Motor Co this could represent half-finished cars still on the production line). Finished Goods are goods that are ready for sale and do not require any further work done. Goods in transit are generally finished goods on their way to a point of sale. Creditors: Creditors represent a liability, whereas Receivables and Inventory represent assets for a company. A Trade Creditor balance is recorded on the balance sheet of a company when it has purchased goods for its inventory (or to on-sell to its own customers) for which it has not paid cash yet. There are two other Working Capital items that are noteworthy but less common. Prepayments represent the opposite of a creditor, when the company has paid for inventory or some other

product without having received it yet, and is recorded as an asset on the balance sheet. Deposits are the opposite of a receivable, when the company receives cash for a sale prior to providing the goods it is selling to its own customers. Deposits are recorded as a liability on the balance sheet of the company. The three items Receivables, Inventory and Creditors combine to form what is known as the Cash Collection Cycle of the Company. The Cash Collection Cycle of a company looks at how long a dollar has to be invested in the working capital of a company prior to recording a sale (and hopefully some gross profit!). The Cash Collection Cycle works as follows:

A company provides 60 day payment terms to its customers, meaning that once it provides goods to a customer it takes 60 days to get cash from them. This increases the cash collection cycle by 60 daysas money is invested in the sold product by the company for the 60 days until it is received from the customer; A company carries inventory on its shelves for 40 days. For the entire 40 days the company has therefore invested cash in a product on its shelves. This is added to the days receivable (60 days from the point above) to mean our cash collection cycle is at 100 days. A company gets creditor terms of 30 days from its inventory supplier, meaning that for the first 30 days that the inventory sits on its shelves, its supplier actually has its money invested in the inventory instead of the company. This reduces the cash collection cycle by 30 days as the company does not need to use its own cash during this period to fund the inventory. This -30 days combines with +60 from Receivables and +40 from inventory holding period to provide a total cash collection cycle of 70 days. The 70 days represents the amount of time that the company has to use its own money to fund inventory prior to receiving cash for the sale of the product.

In part two of this we will discuss the pros and cons of having different cash collection cycle structures.