Entrepreneurship, Second Edition

11.3. Working Capital: Getting Cash from Receivables and Inventories

The timing of collection of accounts receivable and payment of accounts payable is a key determinant in whether a firm is cash rich or cash poor. For example, an increase in net working capital (that is, current assets minus current liabilities) doesn't necessarily translate into an increase in liquidity. One reason is that increases in net working capital often result from increases in operating assets, net of increases in operating liabilities. These operating assets, such as accounts receivable or inventory, are usually tied up in operations, and firms don't commonly liquidate them (prematurely) to pay bills, typically paying with liquid financial assets, such as cash and marketable securities, instead. Thus, we can use only liquid financial assets to assess a firm's liquidity.

Further, corporate insolvency usually results when the firm fails to service debt obligations or callable liabilities on time. We can estimate corporate liquidity fairly accurately by taking the difference between liquid financial assets and callable liabilities, referred to as the net liquid balance. The net liquid balance is actually a part of net working capital. Net working capital is easy to calculate in one of two ways:

Take the difference between current assets and current liabilities (as described earlier), or

Take the difference ...