Sunday, February 14, 2010

[Operating] Working Capital - What's the Difference?

I was working with a buddy on a financial model recently and this came up as an issue. It's very confusing because Working Capital is defined by operating assets and liabilities (short term or current assets and liabilities) and it *seems* synonymous with Operating Working Capital, which it is not. First, the definitions:

Working Capital is defined as:
WC = CA - CL
CA - Current Assets
CL - Current Liabilities

However, when doing M&A or LBO's we aren't concerned with Working Capital as much as we are with Operating Working Capital. Why?

Cash and Short Term debt instruments are actually financing components and aren't actually included in Operating Working Capital (OWC). In an acquisition, the target firms capital structure is usually zeroed out (unless there is a debt roll over clause) and the capital structure used to purchase the company is plugged in (including good will, recognisable intangible assets etc).

So Operating Working capital has some adjustments:
OWC = CA - CL - Cash + Short Term Debt

It's the same idea as excess cash rather than cash in Enterprise Value.

9 comments:

Michael - BCA said...

Great post! Thanks for the information it will be very helpful.

Giridhaar said...

Hi Joshua,

I am having trouble understanding the reasoning behind why Short Term Debt is ADDED in the OWC formula. Why would short-term debt INCREASE OWC? It seems counter-intuitive to me. Could you please explain to me the reasoning behind removing cash and adding short term debt in this formula?

In my textbook, there is an example with Target which states "As Target is able to finance a portion of its net operating assets through non-interest bearing long-term liabilities, its NOAT is significantly higher than its traditionally defined asset turnover".

Would you also be able to explain the above quote to me in relation to OWC and the NOAT formula please?

Sorry if this is confusing... I'm quite lost about what all this means. If you could help me out with this I would greatly appreciate it.

Kind Regards

Giri

Joshua Wong said...

Hey Giri,

I hope I wasn't confusing things more than clearing things up. The only reason I wrote that formula was because my buddy who originally asked me why his boss was asking to make the adjustments. It absolutely does seem counter intuitive.

Rather than say that Short Term Debt is removed from Working Capital (defined as CA - CL, and CL INCLUDES Short Term Debt and CA includes CASH) to produce OPERATING Working Capital, it would be more accurate to say that Operating Working Capital is Working Capital EXCLUDING financing capital.

Pure math answer:
WC = CA - CL
CA = Cash + A/R + Inv + Liquid assets (liquidate within a year)
CL = Accounts Payable + Wages Payable + Short Term Debt + Liquid Liabilities (due within a year)

To adjust for (remove) financing items (cash and Short Term debt):
OWC = (CA - Cash) - (CL - Short Term debt)
= CA - CL - Cash - (- Short Term Debt)
= CA - CL - Cash + Short Term Debt

Remember, Cash has a special relationship related to financing so it's not really strictly considered operating (I have a seperate post on the idea of "excess cash") and Short term debt is actually a financing decision (not operating strictly speaking).

http://amgstr.blogspot.com/2009/12/enterprise-value-cash-how-much-is-too.html

So basically, loading up on Short Term debt doesn't increase your *O*WC (because OWC *is not affected by short term debt*). However, loading up Short Term debt will DECREASE your WC.

Another way to think about it, operating items are those directly related to how you operate "as an ongoing business". Financing items, such as short term debt, are strictly related to financing decisions. (See also my post on Operating Strategies versus Finance Stratagies as described by our world renowned Strategy Prof. Anita McGahan).

http://amgstr.blogspot.com/2010/03/operating-leverage.html

Fantastic question! Thanks!

Giridhaar said...

Joshua!
Thanks so much for replying to my question. You explained it really well! I tried it out with some numbers and I understand what you mean.

This a great blog. You cover a wide range of topics. I'm in my last semester of a Commerce Finance/Accounting degree and I was curious about postgraduate courses. I feel that a bachelor of commerce is really general and topics aren't covered in enough depth. In what course did you study about all the things you write about in your blog? I'm quite interested in learning about derivatives and valuation in more detail... do you have any recommendations as to what kind of program would help me best achieve that?

Anyways, thanks once again for your help.

All the best!

Giri

Joshua Wong said...

Thanks Giri, I really appreciate that.

As an engineer, friends have always said "I'm sure you've got great technical skills, but nothing on your resume says 'finance'" so this blog was a first step (or even a diary) of my efforts to learn more about finance. My degree was Engineering and Management (all core Engineering and Commerce degree courses) but you're right, it feels like it could use more 'meat'.

I often get asked what is the best way to learn more, specifically about the details of an MBA versus a CFA so recently I put up a little post outlining the differences.

http://amgstr.blogspot.com/2010/04/mba-or-cfa-whats-difference.html

Having said that, I don't really think there is any substitute for experience. I was fortunate to spend a summer in New York at a Hedge Fund before doing my Rotman MBA through the Analyst Exchange program which really helped me as well.

http://www.theanalystexchange.com/

Other than that, some of the ideas are just questions that pop into my head: "I wonder what would happen if..." or a buddy asks me questions: A friend asked me a question about butterfly options (I didn't know what they were, but we reasoned it out to the right answer, an upcoming post!)

At the risk of sounding like a huge finance geek, I actually do find it enjoyable and really appreciate when people are willing to take a different look at the mechanics of what makes things tick.

John said...

Joshua! I truly appreciate the clarifications that you've made. The formula made understanding a lot easier actually.

My brother is helping me out in establishing a new business. We've talked about OWC and WC. sadly, he seemed to have interchanged those two. Good thing I saw a clarification post from you. My family is currently securing some restaurant loans coupled with receivable financing. The explanation that you gave can definitely help me in understanding where the debts fit in the whole capital equation. Thanks!

Joshua Wong said...

That's great, John! Thanks for the comment.

Aleena said...

Could you please explain to me the reasoning behind removing cash and adding short term debt in this formula?

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Credit Release said...

Beautiful post for business owners to get a better picture of what the terms are. Most of us would have experienced it before but few would understand what it means.