Every company has two investment cycles: a short cycle, over twelve months, i.e., the current fiscal year, in its current assets, which in turn funds its day-to-day operations; and a long cycle, amortized over several years, in its fixed assets, which funds its development.
The working capital requirement corresponds to the first. It equals the cash or, in theory, assets that can quickly be converted into cash that the company must keep at its disposal to finance its operations in the current year: cash, short-term investments, inventories and current receivables.
Some activities are remarkably light on working capital: typically, customer collections are rapid, or immediate or pre-delivery to the goods or services purchased, and there are no inventories.
In the best case, because clients pay well before the company pays its suppliers, there is literally no working capital requirement, i.e., no capital to mobilize to finance day-to-day operations.
Other activities, however, suffer from a much more demanding working capital requirement. They generally correspond to sectors where customers are slow to settle, and where, upfront for any commercial expansion, substantial inventories must be piled up.
A perfectly illustrative - almost caricatural in itself - example is that of a producer of spirits, such as cognacs, whiskies, wines and champagnes. The buildup of its inventories weighs structurally and penalizes cash flow from operations.
Often, an increase in the working capital requirement, which thus mobilizes more resources and compresses the free cash flow theoretically distributable to shareholders, will be seen as positive because it reflects a business expansion.
Conversely, a decrease in the working capital requirement, which suddenly frees a large amount of cash distributable to shareholders, may reflect a contraction of activity and thus a worrying momentum over the longer term.
The analysis of the working capital requirement is a complex exercise reserved for seasoned analysts - those who understand the seasonality of the business and keep a sharp eye on nuanced ratios such as inventory turnover, the ratio of invoices issued to invoices to be settled, etc.
The aim of this article is not to delve into these encyclopedic details, but simply to underline that a business with a reduced or negative working capital requirement, because it is less capital-intensive, remains inherently easier to manage through cycles and generally more lucrative for shareholders.
See also ABC of Financial Analysis: the six pillars of asset valuation.
