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J. B. Weaver and F. S. Lyndall Atlas Powder Co.
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W O R K B O O K
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The Elements of Working Capital Liquid assets are needed along with fixed investment — and liabilities come too
IN Λ NEW chemical venture, most of the engineering emphasis is natu rally placed on design and estima tion of investment for equipment and other facilities—the fixed capital. However, in the three-year period from 1955 to 1957, 18% of new in vestment by the chemical industry was put into working capital as com pared with 6 9 % in plant and equipment and 1 3 % in other as sets [Chem. Eng. News 36, 60-4 (June 2, 1958)]. This indicates that cost engineers should give at tention to the estimation of working as well as fixed capital. Working capital has been dis gracefully neglected in the cost es timation literature. It is given short shrift in recent books on chemical and engineering economics, and most established texts on engineering eco nomics omit it completely. The reason for this lack of emphasis is obscure. It hardly seems proper to spend several months to develop the fixed investment estimate, and then allocate 10 minutes to estimate work ing capital as, for instance, 3 months' sales value. From at least one point of view, working capital is really more fixed than fixed investment and is there fore worth still more care in esti mating. Like land, working capital is not depreciated over the life of an investment, nor tax deductible as an expense. It is considered to be liquid and convertible into cash at any time the project is terminated. However, the tax laws allow de preciation to be reported as a non
cash expense over the life of the equipment, reducing taxes and there fore resulting in early partial re covery of the fixed investment. This was discussed in February and April. As there is no such allowance on working capital, it must be main tained for the entire life of the project. Definition
For economic evaluation of pro posed investments, working capital must be defined as the funds in ad dition to the fixed investment which a company must contribute to the project. These must be adequate to get the plant operating and to meet subsequent obligations as they come due. However, nonrecurring start-up expense should not be con sidered as working capital, because (unlike working capital) it can be written off as a business expense. Inventories
The easiest element of working capital for which to estimate some sort of value is inventory. Raw material, in process, and finished product inventories should all be considered. Several texts have pub lished rules of thumb which can be used to estimate inventories in terms of days' supply within the plant. To emphasize the fact that these should not be used indiscriminately, they are not repeated here. Better figures can be obtained from a short investigation of your own company's experience on similar materials at existing plants. I/EC
Variations in the size of inven tories can easily be seen by contrast ing such interchangeable materials as natural gas and fuel oil. Natural gas is delivered from a pipeline; no raw material inventory is main tained and the plant is billed for it after use. This actually represents a use of suppliers' money, because the plant is putting directly into in-process inventory a material re ceived but not paid for. By con trast, fuel oil can be obtained most cheaply in tankers or barges which may require considerable value in raw material inventory at all times, to be sure not to run out. Some use of suppliers' money might be in volved between receipt and pay ment, but paid-for raw material would be in the plant for some time before use. Raw materials should, of course, be valued at their delivered cost to the plant. However, finished prod ucts represent negotiable materials of sale to which the value of manu facture has already been added. Although there arc arguments in favor of valuation at product price, working capital as defined here is the cash outlay required to support the product. The consistent ap proach then is to value finished product inventories only at the cash value of the funds which the company has put up to create them. This would be cash cost rather than product price, and would exclude noncash items such as depreciation, profit, etc.
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ORKBOOK
FEATURES
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I/EC COST . A Workbook Feature Accounts Receivable
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Accounts receivable represent goods which h a v e been sold to a customer b u t a r c not yet paid for. V a l u a t i o n of accounts receivable, for the purpose of d e t e r m i n i n g the working capital investment required by the c o m p a n y , is a g a i n a p r o b l e m . It is usual to show t h e m at sales value on the balance sheet. H o w ever, on a cash basis, the investment by the c o m p a n y in accounts receiv able is only the cash cost of the p r o d u c t (including freight and ship ping charges if a n y ) . Accounts P a y a b l e
Accounts p a y a b l e represent the goods, services, etc., which are avail able for use in the plant a n d h a v e not yet been paid for. Depending on the occurrence of pay d a y for various parts of the labor force, most companies accrue a consider able " a c c o u n t s p a y a b l e " as wages or salaries payable, representing labor's value a d d e d to these vari ous products. I n a s m u c h as the labor is expended on the c o m p a n y ' s products before it is paid for, the employees are essentially a d v a n c i n g money to the c o m p a n y . Payment for utilities is also after the d a t e of use a n d should likewise be considered a source of funds. Payables should be included in working capital analysis, to find the a m o u n t of c o m p a n y funds required over a n d above the fixed investment. E a c h a c c o u n t p a y a b l e represents a definite d e t e r m i n a b l e obligation on the p a r t of the c o m p a n y , so valua tion of accounts payable should provide n o p r o b l e m to the esti m a t o r . T h e terms of sale of p r o spective suppliers can be d e t e r m i n e d directly. Taxes P a y a b l e
T h e rules of t h u m b concerning working capital (15 days of this a n d 30 days of that) were a p p a r e n t l y m a d e u p before the federal income tax b e c a m e such a significant con sideration. E a c h profitable sale in curs a n obligation to pay taxes, b u t until t h a t obligation becomes d u e , the cash equivalent of the tax portion, w h e n received from the cus tomer, is usable as cash working capital by t h e c o m p a n y . If tax able income is considered to be
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INDUSTRIAL AND ENGINEERING CHEMISTRY
e a r n e d uniformly over the year, accrued taxes p a y a b l e now r a n g e between 5 τ / 2 a n d 8V2 m o n t h s a n d average 7 m o n t h s ' taxes. Any profitable investment adds profits, a n d the taxes accrued on such prof its m a y in some cases offset all the other items of working capital con sidered above. As profits a c c u m u late, the working capital provided from taxes p a y a b l e frequently re duces the working capital required by a going project. Cash
Cash is the last element of work ing capital to be considered. I t is the balancing factor in the trans actions of any business. O n c e a c o m p a n y or a project reaches steady profitable levels, cash r e q u i r e m e n t s c a n be supplied from operations. Cash is needed only to take care of the nonuniformity of the cycle (within the m o n t h or seasonal). Cash held in excess of this require m e n t is really idle, not working capital, held for reasons other t h a n i m m e d i a t e needs. T h e rules of t h u m b which a r e available for estimating this element seem to b e a r no relationship to actual needs. A m i n i m u m cash b a l a n c e must be m a i n t a i n e d to cover t h e expected a n d also t h e r a n d o m variations in receipt of income vs. bills. Combining the Elements
U n l i k e fixed investment on a project, most of w h i c h is generally spent consecutively over a relatively short period, working capital is a balance between continuous cash flows in a n d out of the project t h r o u g h o u t its life. T h e elements dis cussed here provide the basis for p r o p e r estimates of working capital. I n August, we will discuss the time cycles involved, a n d the contrast between the cash and the a c c o u n t i n g definition of working capital.
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