Working Capital Adjustments Part 1

Quick reference

• 00:04 Before I started talking about the four different types of input last time out
• 00:08 as a bit of a cultural interlude, I was in the middle of calculating revenue.
• 00:13 Well let's go back to that.
• 00:14 What exactly am I doing when I'm calculating revenue?
• 00:17 Well, I'm calculating the Sales and that's only a p and l figure.
• 00:21 If I sell a million units at a dollar each, that's a million dollars accrued.
• 00:26 But how much have I actually received cash-wise?
• 00:29 There's two elements here.
• 00:30 Is everyone paying for start, and if so, how long are they taking?
• 00:34 Am I going to get it all in in the period?
• 00:37 We need to consider these working capital adjustments of consequence.
• 00:41 Let's take a look.
• 00:42 Let's back up at how we're actually building our model.
• 00:46 So you may recall I said a model is stream line process to get from A to B.
• 00:52 And we have this arrow graphic.
• 00:55 First of all, you build your checks and
• 00:57 then the various modules, we're looking at revenue in the operation section.
• 01:01 But my question is, really are some of the other
• 01:06 elements needed to calculate the impact on the financial statements?
• 01:11 And the answer is, why yes, can you guess which one?
• 01:17 That's right, working capital adjustments.
• 01:20 Now what do I mean by Working Capital Adjustments, and
• 01:23 further what do I mean by working capital?
• 01:26 Well, the Working Capital Adjustment is actually the effect of adjusting the p and
• 01:32 l to get the cash number.
• 01:33 So sometimes it's going to be due to data receivable for
• 01:37 sales and it could be days payable for costs.
• 01:40 Now the definition of working capital is slightly different.
• 01:43 An account, we'll define it,
• 01:44 as the current assets, that is, assets that are used in the business and
• 01:49 have a life of less than 12 months less corresponding current liabilities.
• 01:55 It measures how much in liquid assets accompany has available
• 01:59 to build it's business.
• 02:00 Now liquid assets are those that can be readily converted to cash.
• 02:04 So, somethings aren't that easy to actually convert to cash so they should be
• 02:08 excluded and that's why analysts will often only consider trade receivables,
• 02:12 trade payables, and inventory.
• 02:13 This number can be positive or negative but obviously if a company is growing,
• 02:17 you really would prefer it to be positive.
• 02:19 Because if it's negative, there's an inference here that, in the short-term,
• 02:23 a company may struggle to actually pay its bills,
• 02:25 because it's tied up in the working capital cycle.
• 02:29 And the cycle means it's money that's invested that eventually shakes
• 02:32 loose again, but how long will it take?
• 02:34 So, if you're a manufacturer or something like this,
• 02:37 you might have a cycle that looks like the following.
• 02:40 Look, this is just an example,
• 02:42 there will be others which have more than these things in there.
• 02:44 And there will be others which some of these elements do not apply.
• 02:48 But, first of all, to buy your actual goods you are going
• 02:50 to sell in terms of your raw materials, you need to raise a purchase order.
• 02:55 Then you store the raw materials in the inventory, it might be you need
• 02:58 to grow them first or you need to actually fine tune them and get work in progress.
• 03:02 Maybe apply other production resources before they're finished goods.
• 03:05 And they'll also, again, stay in stock.
• 03:08 Then, you might have to distribute them to retail, shops, or
• 03:11 warehouses before you can make a sale.
• 03:14 Now some of those sales will be up for cash and others will be on credit terms.
• 03:17 And how long will they take to pay?
• 03:19 How many debtors do you have?
• 03:20 Or are there receivables?
• 03:22 Eventually you get the cash receipts and then you'll be able to free it up and
• 03:25 start all over again.
• 03:27 The aim is to make that cycle as small as possible.
• 03:32 Let's have a look at how we can estimate those days then
• 03:35 by using often the control account.
• 03:38 So in this particular example,
• 03:40 I'm going to assume that it can be just starting off, and so therefore,
• 03:43 there is initial account receivable by e, other stuff nobody owes us money.
• 03:49 Recall that with a control account, the top and bottom lines of a control account
• 03:54 actually show the effect on the balance sheet previous period and current period.
• 03:59 Now I'm making sales of a $1000 in the period and I'm receiving cash in of $753.
• 04:05 That means I'm still owed $247 at the end assuming there's no bad debts.
• 04:11 That's great, but
• 04:12 how can I turn that into how long is it all tied up in working capital?
• 04:16 Well, I could derive some complex formula.
• 04:20 I'm not going to do that.
• 04:21 I am going to derive a complex formula using and that's different.
• 04:27 So imagine I have an income statement where I accrue my $1000 of
• 04:31 sales evenly over a slight period, let's just pick up a random number.
• 04:36 I don't know, let's use 365 days.
• 04:40 Let's make a copy of that.
• 04:42 Thank you.
• 04:43 We'll convert that to cash by actually showing it as a credit period
• 04:46 before people pay.
• 04:48 Maestro, please.
• 04:49 Thank you.
• 04:50 So what's happening is, the cash comes in after the credit period.
• 04:54 So sales made right at the beginning come in after the credit period,
• 04:58 then they continue to keep coming in evenly, as you see here,
• 05:01 with some of them coming in after the end of these 365 days.
• 05:06 So to recap, originally, I had $1,000 worth of sales.
• 05:09 That translated to only $753 of cash in the period,
• 05:14 which means $247 is still outstanding.
• 05:18 That's the same length as the credit period.
• 05:21 So I can see that my credit period is clean just looking at this image,
• 05:27 247,000 of 365 days.
• 05:29 Formulaically, my accounts receivable is my sales in the period, that's 1,000,
• 05:35 multiplied by the days receivable divided by the days in the period.
• 05:38 I can work it out this way.
• 05:39 Rearranging that, I can work it out.
• 05:43 I've got 247 over 1,000, times 365, gives me 90 days.
• 05:49 And that's how I can calculate it in a model, and I can rearrange it to calculate
• 05:55 what my receivables are should I actually need to work out what the cash effect is.
• 05:59 And I'll give you an example of that
• 06:00 when we look at the Excel example next time out.
• 06:03 Just to wrap up this section,
• 06:05 do remember you should only apply this to the credit items.
• 06:08 It's not really applicable for unpredictable receipts and
• 06:10 payments if you're expecting it to come in evenly.
• 06:13 If it's monthly modelling working capital, be careful because if your days
• 06:16 receivable or days payable is above that, it's nonsense,
• 06:20 we're not including bad debts, and you should not count any billed revenues.
• 06:23 So if people have paid you for
• 06:25 services not rendered, that's got to be adjusted for first.
• 06:29 All right, let's go and have a look in the next session at the Excel example.

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