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Working capital isn't the answer (but cash is)

cash management companies working capital Mar 22, 2023

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Working capital isn't the answer (but cash is)

Toys R Us was an iconic store that every child loved.

But, the story ends with a dramatic bankruptcy and shuttering of the business.

What happened, you may ask?

Toys R Us was a leading baby and toy retailer that had its share of successes.

It had grown tremendously and was dominant in the toy market.

But by 2005 a combination of large discount retailers, online shopping, and massive debt made their future uncertain.

As the toy market continued to grow, their revenue continued to shrink.

As sales lagged and they struggled to adapt, outside parties became interested in buying and revitalizing the retailer.

In the end, a group of private equity firms came in and “rescued” them from their struggles.

They immediately made cuts but also loaded the business up with over $5 billion in debt.

This debt meant Toys R Us owed over $400 million PER YEAR in interest to service the loans.

When the debt was taken out, while it was a large increase in overall debt, there was no issue repaying the debt based on previous conditions.

But you don’t pay debt based on the past, right? You have to be able to pay the debt based on the current conditions.

Revenue continued to decline.

Margins were squeezed because of competition.

The 2008/9 recession meant they sold through less inventory than expected.

They found themselves in a deeper and deeper hole, eventually leading to their bankruptcy filing in 2017. See their dismal gross margin decline below. This plus debt was the ultimate nail in the coffin.

Working Capital: does it matter?

So, let’s talk about what this means in regard to working capital.

First, let’s define it:

Working Capital = Current Assets minus Current Liabilities

When you divide Current Assets by Current Liabilities, you get the Working Capital Ratio (or Current Ratio).

The goal with this ratio is to have more current assets than current liabilities, but not too much. Traditionally this is between 1.0 and 2.0, but different situations require different things.

Logically, when you think about this, it makes sense.

Having more current assets than current liabilities sets you up in a good position to cover short-term liabilities.

When you can’t meet short-term liabilities, you’re forced to make less-than-ideal decisions to meet those obligations:

  1. Liquidate assets (inventory) for less than value
  2. Take on long-term debt to cover short-term need
  3. Sell shares or contribute money to cover the shortfall

So, let’s dig a little deeper into what each of these elements are.

Current assets consist of:

  1. Cash and cash equivalents
  2. Accounts Receivables
  3. Inventory

Current Liabilities consist of:

  1. Accounts Payable
  2. Current portion of long-term debt (due in less than a year)

Remember: Toys R Us took on a lot of long-term debt. That long-term debt is not reflected in this formula. In 2005, before the leveraged buy-out, their liabilities & equity consisted of 30% debt and 70% equity. By the time the deal was finalized, that ratio had shifted to 78% debt and 22% equity.

Where does equity come from? Based on the Balance Sheet formula (Assets = Liabilities + Equity), that means assets have decreased or liabilities had grown.

Let’s use an example. Say they had $2 million in cash & other current assets and $1 million in current liabilities before the buy-out.

During the buyout, they added $5 million of debt and took out that cash and no more.

The working capital ratio would still be 2.0 ($2 million / $1 million), not reflecting the new debt in any way.

But because the debt load was so high, that changes cash coming into the business. Their interest expense would be high, which lowers profits from the Income Statement. That reduces equity growth and ultimately cash growth.

We saw this exact thing with Toys R Us. The chart below shows their debt before and after the leveraged buyout.

So, do you still care what the ideal working capital number is? We might be looking at the wrong number:

  1. It doesn’t take into account debt
  2. It doesn’t take into account expected profits
  3. It includes less liquid accounts receivable and inventory

Ratios like the Cash Ratio (Cash + Cash Equivalents / Total Liabilities) and Quick Ratio (Current Assets - Inventory / Current Liabilities) help you get a better feel for what’s more liquid, but just managing cash is always so much easier.

How much cash do we need?

So, how much cash do we want to have on hand?

This is a tough question that I’m going to attempt to answer.

I put together a little chart, inspired by one Brian Feroldi put together on a personal emergency fund.

While businesses are more complex than personal finances, we’re going to create a formula and include:

  • Stage of business
  • Your business goal
  • Capital needs
  • Industry stability
  • Seasonal fluctuations
  • Customer concentrations
  • Supplier-related exposure

Start at the left and move to the right, adding or subtracting based on which of each element most identifies with your business.

This model is for companies with profit, as those burning money need to pay more attention to cash burn rate.

It is rough, and not completely refined, but it made sense (to me) for the different businesses I ran it through.

Would you let me know how your business faired and if you think it’s accurate?

Let me know through this poll below. Comments and suggestions are appreciated as it’s still a work in progress.

How good is the formula?

Please add your comments!

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Something Interesting

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