Is your business running smoothly day-to-day? If not, the issue might be hidden in your working capital management. Welcome to the first article in our three-part series on mastering working capital, a critical element in maintaining a healthy business. Today, we’ll dive into the fundamentals—Net Working Capital, the Current Ratio, and the Quick Ratio/Acid Test. In part two, we’ll explore the Cash Conversion Cycle and in part three, the Weighted Average Cost of Capital (WACC).
At the end of this article, there is a web tool to check out the Net Working Capital and ratios of other Belgian companies.
Key Take-aways:
- Net Working Capital consists of several components that can significantly impact available working capital, so managing them correctly is vital.
- View the metrics in context of their industry and only compare them to companies with similar operations.
- Review metrics regularly, remembering that Net Working Capital, Current Ratio and Quick Ratio are only a snapshot at a certain point in time.
Understanding Net Working Capital
Net Working Capital (NWC) is a key metric that assesses a company’s liquidity and operational efficiency by evaluating its short-term assets and liabilities. Essentially, it’s the difference between current assets (e.g., cash, accounts receivable, inventory) and current liabilities (e.g., accounts payable, short-term debt). Analyzing your NWC helps determine if your business has the financial flexibility it needs.
The formula is straightforward:
Net Working Capital (NWC) = Current Assets – Current Liabilities
*In Corporate Finance, ‘current’ refers to a time period up to 1 year or less*
Examples
To illustrate how Net Working Capital (NWC) can differ across industries, we’ll compare three companies using their financial statements as submitted to the National Bank of Belgium, in 2022.
Our three companies will be:
- Dreamland, a toy retailer.
- KPMG, a financial advisory institution.
- Dovy Keukens, a manufacturer of high-end kitchens.
We’ll use the following accounting codes to determine their current assets:
- Inventory (code 3) (voorraden)
- Accounts receivable (40/41) (vorderingen op ten hoogste één jaar)
- Financial investments (50/53) (geldbeleggingen)
- Liquid assets (54/58) (liquide middelen)
- Accrued accounts (490/1) (overlopende rekeningen)
For current liabilities, we’ll use:
- Current debt (42/48) (schulden op ten hoogste één jaar), including:
- Accounts payable (44) (handelsschulden)
- Accrued accounts (492/3) (overlopende rekeningen)
*This chart is interactive. Click and drag to zoom in or (de-)select categories in the legend.
Know Your Company
Net Working Capital is simply a snapshot of your company’s financial position at a specific moment in time. At first glance, Dreamland might seem to be in the best position because it has the highest NWC among the companies we’ve examined. However, reality paints a different picture. Despite its high NWC, Dreamland was struggling in 2021, which led Colruyt Group to sell its majority stake in March 2023 because the business was no longer viable.
Let’s break this down:
- Dreamland has an inventory valued at €73.772.969. If they were to sell all of it today, they would convert this into liquid assets of the same value.
- Dovy Keukens has an inventory valued at €28.845.696. If they were to use this inventory to construct new kitchens and then sell them, that money would become a liquid asset.
However, the nature of these inventories is vastly different. Dreamland’s inventory consists primarily of toys, products that are heavily influenced by trends, seasons, and other market forces. In contrast, Dovy Keukens’ inventory consists of raw materials and components necessary for manufacturing high-end kitchens. For Dovy Keukens, these materials are not the end product but rather the means to create a product.
The key difference is in risk. Dreamland faces the risk of significant loss if a new toy hits the market before they can sell older inventory, not to mention the costs of storing unsold goods. That €73 million in inventory could lose value rapidly. Dovy Keukens, on the other hand, can convert their inventory into finished products that retain their value and generate revenue upon sale.
*CFOrent-tip*: A high inventory cycle, i.e. how quickly an inventory is turned over, can be problematic. A thorough sales forecast in combination with well-thought purchasing policy will strengthen your business and keep volatility down. Our associates are experts in guiding you and making a well-founded sales forecast and purchasing policy. Get in touch for more information.
Below, we’ll explore the proportion of each type of current activa, for each company:
When we consider Dreamland’s inventory as the most volatile asset within the company’s current assets, Dreamland’s financial position looks more precarious. A striking 75.4% of its current assets are tied up in ‘volatile inventory.’ In contrast, while Dovy Keukens has 70.7% of its current assets in inventory, this inventory is far more stable and likely to retain its value, as we discussed earlier.
Know Your Debt
Let’s examine the short-term debt figures for our three companies:
- Dreamland: €59.109.943
- KPMG: €36.612.051
- Dovy Keukens: €27.797.340
Given Dreamland’s situation, with over 75% of its assets in volatile inventory, the company is in a precarious position, especially when coupled with its substantial debt.
KPMG, with a debt of €36 million, is in a stronger position. The company’s assets total approximately €40 million, with less than 10% tied up in inventory. Dovy Keukens falls somewhere in between, with about 29% of its assets in less volatile forms and a more stable inventory.
The financial world acknowledges the importance of considering both the stability of assets and the amount of debt. That’s why two important ratios come into play:
- Current ratio: current assets / current liabilities
- Quick ratio or acid test: (current assets – inventory) / current liabilities
These ratios help us better understand Net Working Capital (NWC) in a more actionable way. They allow us to say, “higher, lower, or in between is better” based on the context. Inter-industry operations differ substantially so the ratios are only relevant when comparing companies within industries and similar operations. Generally, it is assumed that 2:1 for the Current Ratio and 1:1 for the Quick Ratio are stable ratios. A ratio of less than 1 indicates that the company may have problems meeting its short-term obligations.
By comparing the current and quick ratios, we can better gauge the impact of inventory on a company’s liquidity. Suddenly, KPMG’s financial stability seems much stronger when we consider these ratios. Interesting, isn’t it?
*CFOrent-tip*: The other underlying components of the formula are as relevant as inventory. If payment terms for Accounts Receivable and Accounts Payable are not aligned, cash flow problems will arise sooner or later. Renegotiating payment terms or negotiating discounts for immediate payment can offer relief in these situations, says CFOrent-associate Maxim.
Know Your Competition
The metrics we’ve discussed provide a snapshot, but they don’t account for the inherent differences in business models. For instance, Dreamland and Dovy Keukens have relatively big inventories, while KPMG’s inventory will likely consist of office supplies, worth only €4 million. This variation highlights the importance of contextualising these metrics.
Understanding your competition is crucial. For example, in 2022, Colruyt Group was the majority shareholder of Dreamland, whereas its competitor, FUN N.V., had a more diversified shareholder base. Colruyt Group could leverage its established distribution network, potentially giving Dreamland an edge in inventory management. Conversely, could FUN N.V. match this advantage?
KPMG, along with its rivals Deloitte, Ernst & Young, and PwC, benefits from a global support network that can absorb financial hits. Starting a business in direct competition with these giants requires finding a niche to remain competitive.
Similarly, Dovy Keukens operates as a major player locally but is small on a global scale. Their custom-made kitchens limit their reach to customers compared to IKEA, which has a worldwide presence. While both are well-known in Belgium, they are not necessarily direct competitors.
Conclusion
In this article, we have discussed the Net Working Capital and it’s ratios and we have shown its underlying components. Using our examples, we focused on the component “inventory” and shown the importance of understanding how it impacts the absolute value of Net Working Capital. Later, the ratios have proven to be a more insightful way of understanding the distribution of assets and liability and they can give a clear indication of where the vulnerabilities of a company lie. However, they always have to be put in context and reference with similar companies and are still superficial metrics.
Coming up…
Stay tuned for part two of our series on Working Capital next month. We will cover the Cash Conversion Cycle, a more dynamic and insightful metric than Net Working Capital. It often provides a clearer picture of your business’s liquidity. While Net Working Capital measures your ability to cover day-to-day operations, it doesn’t capture the full picture of how efficiently your capital flows through your business. Even if your Net Working Capital appears healthy, you might still face challenges in paying your bills if your capital is tied up in various parts of your operations.
Are you interested in how other companies perform? Use this tool to find out! All the data comes straight from the National Bank of Belgium and is based on annual financial statements.
Need some inspiration? Check out how our examples are doing today:
In case you want to have a talk about your metrics, Let us know here!
- KPMG – BE 0419.122.548
- Dreamland – BE 0448.746.645
- Dovy Keukens – BE 0428.003.392
Sources
In this article, calculations are based on documents provided by the National Bank of Belgium. The full document can be found here.
