Should Cash Be Included in Working Capital?

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What’s Working Capital?

Working capital represents the amount of funds that a company requires to serve its day-to-day operations. Conventionally, working capital is defined as the difference between current assets and current liabilities:

Current Assets include a company’s short-term assets that are expected to be converted into cash over a 12-month time period. Typical examples for current assets are cash, marketable securities, inventory, and accounts receivable.

Current Liabilities are any type of short-term obligations that the company has yet to meet within 12-months. Short-term liabilities comprise, for instance, accounts payable, accrued expenses, or short-term bank loans.

Measuring a company’s working capital is important because it essentially reflects the capital that most types of businesses need to reinvest in order to grow their core operations.


Should Cash Be Included in Working Capital?

There are several reasons why cash should not be included in working capital.

As opposed to accounts receivable or inventory, cash & cash equivalents is a different type of current asset regarding the purpose it serves and its opportunity cost. That distinction is what fuels the argument of not including cash in working capital. 

The issue that some investors and analysts have with the conventional definition of working capital (i.e. current assets minus current liabilities) is the fact that in reality, companies don’t necessarily require cash as a part of their core operations. 

This doesn’t mean that cash is a useless asset for a business. Quite the contrary, a company should optimally maintain a healthy cash balance to fund various other things that are of importance such as long-term investments (capital expenditures), unexpected expenses, dividends, share repurchases, acquisitions, etc. 

In addition to that, companies do also not just let their cash pile up in one single place until it is used for a certain need. The cash & cash equivalent line item on every company’s balance sheet usually represents money that is spread out between money market funds, treasury bills, and other short-term securities which all have a very low-risk profile and can quickly be converted into actual cash once the company needs it. 

Companies earn a certain return for placing a large amount of their cash into such investments. Even when these returns aren’t very high, they are still considered fair given the nearly zero amount of risk that the business has to bear for them. The result is that cash & cash equivalents do not have an opportunity cost unlike the other types of current assets that actually represent a company’s working capital, which is why they should not be included in the definition of working capital.


Non-Cash Working Capital

Following the reasons of why cash should be excluded from working capital, there is an alternative working capital definition, commonly known as non-cash working capital which is defined as non-cash current assets minus non-debt current liabilities:

Non-cash current assets are all current assets that are not cash, cash equivalents, and marketable securities. In other words, current assets that should be included in non-cash working capital are

  • Inventory
  • Accounts Receivable
  • Prepaid Expenses
  • Other current assets

 

Non-interest bearing current liabilities consists of all current liabilities excluding short-term debt or any type of other interest-bearing obligations (like accounts payable & accrued expenses)

We also exclude any interest-bearing current liability from non-cash working capital because it is already included in the calculation of the firm’s cost of capital.


Example: Microsoft Corp.

The following two tables include Microsoft’s current assets and liabilities based on the company’s 10-K for the fiscal year ending June 2021:

Current Assets:

2021

Cash & cash equivalents

$14,224m

Short-term investments

$116,110m

Total cash, and short-term investments

$130,334m

Accounts receivable

$38,043m

Inventories

$2,636m

Other current assets

$13,393m

Total Current Assets

$184,406m

What’s stands out from Microsoft’s current assets is the huge amount of cash that the company currently holds. Around 63% of the firm’s total current assets consist of cash and marketable securities. It may become obvious that a technology conglomerate like Microsoft doesn’t need this amount of cash just to run its operations, which is why the conventional working capital ratio would be heavily distorted if we included cash in its computation.

Current Liabilities:

2021

Accounts payable

$15,163

Current portion of long-term debt

$8,072

Accrued compensation

$10,057

Short-term income taxes

$2,174

Short-term unearned revenue

$41,525

Other current liabilities

$11,666

Total Current Liabilities

$88,657

If we wanted to calculate Microsoft’s conventional working capital as of June 2021, we would need to subtract the total current liabilities of $88,657 million from total current assets of $184,406 million:

Conventional Working Capital = $184,406m – $88,657m = $95,749m

According to the conventional computation, we would arrive at a very high working capital figure. This number, however, would not realistically represent the amount of capital that the company needs to run its core operations. A software business like Microsoft only requires minimal capital since most of the products that the company sells aren’t physical and thus don’t need to be kept in stock. 

Unless we are dealing with a company that needs to maintain a large cash balance for its day-to-day operations, it wouldn’t make any sense to include cash in working capital, which is especially the case with a tech business like Microsoft.

As a consequence, calculating the non-cash working capital for Microsoft would give us a clearer picture of the company’s actual working capital needs. Microsoft’s non-cash current assets were $54,072 million whereas non-interest bearing current liabilities equaled $80,585 million:

Non-Cash Working Capital = $54,072m – $80,585m = $(26,513m)

If we don’t include cash as a current asset, Microsoft’s non-cash working capital would be negative $26,513 million which might raise alarming concerns at the first glance. Whether that’s a good or bad sign heavily depends on the type of business but in Microsoft’s case, this is actually to be expected and completely normal.

In this instance, the negative working capital is primarily caused by Microsoft’s unearned revenues that are coming from its licensing products. This characteristic is typical for most software and subscription businesses and therefore shouldn’t raise any red flags. 


Example: Microsoft Corp.

  • Reasons, why cash should not be part of working capital, include that in most cases, cash is not actively used by a company to run its core operations and that it already earns a fair return and thus doesn’t have an opportunity cost, unlike other current assets.
  • Whether cash should be included in working capital will depend on the type of business and the cash requirements to run its day-to-day operations.
  • What makes a “good” working capital figure is dictated by the company’s industry and individual business model.

 

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