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Pillole di finanza - Il Capitale Circolante/Working Capital — Transcript

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0:03Good morning everyone, I'm Alberto
0:05Dell'Aqua, I teach corporate finance at
0:08the Nibi Master's program on business
0:11internationalization, and today we'll
0:13cover this finance brief on working
0:15capital, a topic I would call vitally
0:18important for companies and for those
0:20who manage them. What is working
0:25capital? Well, working capital is a
0:29metric—I’ll explain how to
0:32determine it—that is useful for
0:40understanding a company's financial
0:42balance and is a figure that has
0:47significant financial implications. I
0:53should also mention that working
0:55capital is often referred to by the
0:57English term "working capital." The
1:04term "working capital" perhaps gives us
1:07a better idea of what it entails.
1:12Capital that works, or capital derived
1:15from the company’s operations. In
1:19effect, working capital is the capital
1:21used or generated by the activities a
1:24company performs every day as it
1:26operates. Essentially, working capital
1:30originates from the so-called purchase,
1:32transformation, and sales cycle—that
1:34is, what a company does every day. How
1:38do we go about calculating working
1:40capital? How do we determine it? Well,
1:43in fact, working capital is an
1:45aggregate, a financial aggregate, and
1:47therefore it is composed of several
1:48items. So, let me remind you briefly
1:52that working capital has to do with
1:55this cycle, the cycle of purchasing,
2:01transformation, and selling. A company
2:14buys raw materials, transforms them
2:16through a production process, and then
2:19sells the finished product. We need to
2:25understand the capital that revolves
2:26around this process. Capital revolves
2:31around this process. This capital can
2:36be freed up by the company or absorbed,
2:39because naturally, the financial
2:41implication is the result of either
2:43absorbing capital in this cycle or
2:45freeing it up. It is clear that if a
2:51company absorbs capital while
2:53performing these activities—
2:54purchasing, transforming, and selling
2:57—it will somehow need to finance this
2:59cash requirement, because if it absorbs
3:02capital, it must get it from somewhere.
3:06Whereas if a company frees up capital
3:08from these activities, well, that
3:09certainly has a different consequence.
3:12Now, I would say there will be a
3:14surplus of financial resources that the
3:16company can then use for other things.
3:19To make new investments or to be able
3:21to remunerate its shareholders. Let’s
3:25see how working capital is determined.
3:28To determine it, we refer to the
3:30classic balance sheet structure. In the
3:34classic balance sheet, we have assets
3:42and liabilities. The balance sheet.
3:54Assets are the company’s holdings.
3:57Liabilities are the claims on these
3:59holdings. But we are not interested in
4:02all assets and all liabilities; we are
4:05only interested in certain assets and
4:07liabilities that relate to this cycle
4:09—the cycle of purchasing,
4:11transformation, and selling. So,
4:16starting with the purchasing phase,
4:18what are the assets or liabilities
4:20linked to this stage? Well, a major
4:25asset linked to the purchasing cycle is
4:29that a company buys raw materials but
4:32doesn't use them all in the production
4:36process; it uses only a portion and
4:39saves the rest for future production,
4:42so these raw materials end up in
4:45inventory. So, here we find inventory,
4:52stocks, if you see, stocks of raw
4:58materials linked to the purchasing
5:04phase. I buy raw materials, but I don't
5:08use them all, so a portion remains in
5:10the company as an asset, and as an
5:12asset, it is recorded in the balance
5:14sheet as raw material inventory.
5:20Another element of the balance sheet
5:22liabilities is linked to the purchasing
5:24phase because when a company buys raw
5:26materials, it receives invoices from
5:28its suppliers, but it doesn't
5:30necessarily pay them immediately.
5:33Perhaps it reserves 30 days, or maybe
5:3660, or sometimes even 90 days to pay
5:39them. These are normal commercial
5:43payment relationships that start
5:46between manufacturing firms and
5:48supplier firms. There is nothing
5:51unusual about it. When this happens, a
5:55company has trade payables because it
5:58still has to pay for the raw materials
6:01it purchased and for which the supplier
6:04has issued invoices that have not yet
6:07been paid. So, linked to the purchase
6:11entry, there can be a trade payable
6:13entry. This is in the liabilities,
6:22obviously it is a debt, it is
6:24effectively a right that certain
6:26parties, namely suppliers, have against
6:29companies because they have yet to
6:32receive payments. Okay? This is a trade
6:35payable that is linked to the
6:36purchasing phase. We have looked at the
6:39purchasing phase and these are the two
6:41main elements. Let's look at the
6:44transformation and sales phase. Well,
6:47here we can have some additional
6:49elements that will make up our working
6:52capital. When a company transforms
6:56goods, it processes them with the goal,
6:58obviously, of creating a finished
7:00product and then selling it, but again,
7:02it's not certain that all those
7:04finished products are sold within the
7:06year or that the company manages to
7:08finish the production of all those
7:10products. For example, it is possible
7:14that by the end of the year, the
7:16company has also created a series of
7:18semi-finished goods or goods still to
7:20be completed that go into inventory;
7:22and therefore, in the transformation
7:24phase, for example, stocks of
7:29semi-finished goods arise, products not
7:34yet finished, but the production phase
7:37could also have produced finished
7:40products. but not yet sold. The company
7:44put them into production, brought them
7:46into its warehouse, but hasn't managed
7:48to sell them yet; it might sell them
7:50next year. So, there are also
7:52inventories of products that are
7:59finished but not yet sold. These are
8:03the two main elements that originate
8:05from the transformation phase. Assets,
8:08inventories of finished goods and
8:11semi-finished products, which are
8:13therefore goods the company possesses
8:15and will be able to complete production
8:17on those semi-finished goods next year
8:20and then sell them, just as it will be
8:22able to sell those finished product
8:24inventories. Let’s look at the sales
8:29phase, which is the final phase where
8:31the company manages to complete the
8:33sale of the product. The product is not
8:36only finished but also sold, therefore
8:38it is transferred to a party that
8:40bought it, the customer. It is not
8:43certain, however, that the customer
8:46will pay immediately; sometimes in
8:48business relationships, the customer
8:51might request a payment extension of 30
8:54, 60, or 90 days. In this case, the
8:59company will record receivables in its
9:02balance sheet, receivables from
9:04customers. It is a sort of asset, a
9:12sort of financial asset that the
9:14company has on its balance sheet,
9:16because the company expects to be paid
9:18by holding, let's say, a credit. It has
9:22sent the invoice to its customer, the
9:24customer hasn't paid yet, but an
9:25invoice has been issued and therefore a
9:28receivable is recorded in the company's
9:30balance sheet. This is the additional
9:33element that interests us, which is
9:35linked to the sales phase and which
9:36will define our working capital. In
9:41fact, working capital is given by these
9:43elements taken together, which is an
9:45aggregate. So, I am highlighting this
9:49entire part of the balance sheet which
9:52is the one that interests us, because
9:55that is where all the elements
9:57resulting from that cycle are, which
9:59define how much capital the company has
10:02absorbed or generated to carry out
10:04these activities of purchasing raw
10:07materials, transforming raw materials
10:09into semi-finished or finished products
10:12, and selling finished products. How
10:17can we calculate it? Because we need a
10:20number, we need to understand if the
10:22working capital is +100 or -100. So, we
10:27simply have to do a sum, a correct
10:29algebraic sum, an accounting sum of
10:32these items, remembering that
10:34everything on the asset side has a
10:36positive sign and everything on the
10:39liability side has a negative sign. So,
10:42let's say the equation is quickly set
10:47up. We wouldn't have to do anything
10:50other than add receivables to
11:00inventories. We have inventories of the
11:05type we wrote here: raw materials,
11:07semi-finished products, and finished
11:09products. I write inventories, I mean
11:13all inventories, and subtract
11:16receivables and supplier payables. The
11:28result will be precisely our working
11:31capital. So, let's do a numerical
11:34example so we understand each other.
11:37Let's see that a company had accounts
11:39receivable of 50, recorded inventory,
11:45had inventory of 30 and recorded trade
11:52payables in its balance sheet because
11:54it still has to pay its suppliers 20.
11:59So, the calculation is easy. 50 plus 30
12:03minus 20 equals 60 is the working
12:09capital of this company. How do we
12:13interpret it? We must pay attention to
12:17the sign and we will immediately
12:19understand the financial implication of
12:21the working capital which, I repeat, is
12:23the capital absorbed or generated by
12:25those three phases. If the working
12:29capital has a positive sign, as in our
12:32example, so I can write + 60, here we
12:38have + 50 + 30-20, the total sum is +
12:4060. This means that the company has
12:48generated more receivables and
12:50inventory than payables, so there is
12:53capital of 60. Apparently, it would
12:57seem like positive news because there
12:59is capital of 60. In reality, we must
13:03interpret it in a totally different way
13:07, because this means that the company
13:10has not yet collected money from its
13:13clients, has immobilized goods in the
13:17warehouse, has not yet sold them, and
13:20therefore has not yet realized cash
13:23from these assets against payment
13:26deferrals that have been granted by its
13:30suppliers. so in fact there is capital,
13:33yes, but from a financial point of view
13:36, it has been immobilized, it has not
13:38been realized, it has been immobilized.
13:43Therefore, in a case of this type, the
13:45purchasing, transformation, and sales
13:47process has absorbed capital of 60,
13:49capital that will eventually be
13:51liquidated by the company over time,
13:53because the company will manage to
13:55recover the receivables from clients,
13:57will liquidate the inventory because it
13:59will manage to sell those products, and
14:02in turn will still have to pay its
14:04trade payables anyway. But at this
14:08moment when we are doing this
14:09calculation, the company has absorbed
14:11capital of 60. So let's give this type
14:15of representation. When the working
14:19capital is positive, has a sign, so
14:28receivables and inventory exceed trade
14:30payables. From a financial point of
14:33view and I write it in red, this means
14:41cash absorption and we have gone to
14:49immobilize financial capital there. The
14:53activity of purchasing, transformation,
14:55and sales required a capital absorption
14:58of 60. In our example. Conversely, if
15:01receivables and inventory are lower
15:04than payables, it is as if the company
15:06were using its suppliers to finance
15:11itself, or rather, using the payment
15:13deferrals towards its suppliers to
15:15finance itself. And so, in this case,
15:18if the working capital is negative, has
15:29a minus sign; we, on the contrary, will
15:33find ourselves facing a generation of
15:37cash, for which these activities have
15:41freed up liquidity. And this is
15:49certainly a positive aspect that we can
15:52attribute to a company's financial
15:54management: the fact of generating cash
15:57from typical operations. Not all
16:01companies have this capability or this
16:02luck, as it also depends on the
16:04activities they carry out. Let's say
16:08there are different types of companies
16:10that have different working capital
16:13management processes. Some companies
16:17have a structure that allows them to
16:19generate cash from the purchase,
16:21transformation, and sale process. For
16:26example, think of large supermarkets
16:28where customers pay for goods
16:30immediately, so no accounts receivable
16:33are actually created. The speed at
16:38which inventory moves is such that
16:41stock and inventory levels are
16:43minimized. Retailers try to move goods
16:47very quickly, and they, in turn, try to
16:51delay payments to their suppliers
16:54because a supermarket's bargaining
16:57power is high, as it sources from many
17:01small producers and can request payment
17:05terms of 60 to 90 days. In effect, a
17:09supermarket tends to have working
17:12capital that generates cash, so its
17:15algebraic sign would be this: negative.
17:19Meaning that supplier debts exceed
17:21accounts receivable and inventory. A
17:24manufacturing company, on the other
17:26hand, tends to have a different working
17:28capital situation. What does that mean?
17:32Because a manufacturing company might
17:35tend to hold a very large inventory, as
17:39it needs to have raw materials or
17:42semi-finished goods available in its
17:46facilities to meet market demand. At
17:50the same time, if an industrial or
17:54manufacturing company lacks strong
17:58bargaining power, it may be willing to
18:02accept delayed payment terms when
18:05selling, allowing its customers—often
18:10other companies—to pay 60 days after
18:14the purchase. At this point,
18:16significant accounts receivable are
18:18created. Faced with this, industrial
18:22and manufacturing companies will in
18:25turn try to negotiate payment delays
18:27with their suppliers, asking to pay
18:29them in 60 to 90 days. But these
18:33supplier debts may not be enough to
18:35cover the receivables and inventory,
18:38leading to a positive working capital
18:41situation, or a cash absorption. What
18:45is the ideal situation? Well, it's
18:48clear: the ideal equilibrium would be
18:50for working capital to be zero, meaning
18:53accounts receivable and inventory would
18:56equal accounts payable. In this way,
19:00there would be neither a generation nor
19:02an absorption of cash; there would be a
19:04perfect balance. It is clear, however,
19:07that this balance is not easy to
19:09achieve. Well, many people dream of
19:12turning working capital into a tool
19:14capable of generating cash, but as we
19:17said, that’s not the case for all the
19:20companies we see on the market. When
19:25working capital is positive, meaning it
19:30absorbs cash, it means capital has been
19:35deployed, and therefore, the company
19:39must somehow raise funds to support
19:43this need through appropriate means.
19:50Typically, the cash absorption
19:53generated by working capital is covered
19:56and financed by activating appropriate
20:00forms of bank financing. There are
20:09specific technical forms of bank
20:11financing, which means turning to banks
20:13to cover this capital requirement.
20:18Banks will provide the company with the
20:20capital it needs to support its working
20:22capital. Well, that is all regarding
20:26working capital. I remind you that it
20:29is a very important metric for a
20:30company’s financial equilibrium. It
20:33refers to the purchase, transformation,
20:35and sales cycle. Make sure to keep the
20:38signs in mind because they can be
20:40confusing, but we must analyze how
20:42working capital is composed to
20:44understand if it is a cash absorption
20:46or a cash generation. And that is all.

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