The aim of this tutorial is to illustrate two different methods for calculating working capital adjustments. These methods allow the user to calculate accurate adjustments whether the working capital periods (debtor or creditor) are less than or in excess of the timing resolution of a financial model (e.g. monthly, quarterly, annual).
Trade debtors and creditors
To model accurately cashflow to a business we must understand the role of debtors and creditors, where present, and their respective payment periods.
Essentially, a debtor is an entity which has received a service or product from a business and who is yet to make payment for the receipt of that service of product. Therefore the ‘debtor period’ refers to the duration between (in most cases) receipt of invoice for product and services and then payment of this invoice.
Applying the same logic to creditors (who represent services or products received but yet to be paid for) and using the simple logic that an economic efficient decision for debtors or creditors is to settle their outstanding commitments as late as possible, we can calculate accurately the value difference between the recorded invoice value on the Income Statement and the timing of cash.
This value can then be used as a ‘Working Capital Adjustment’ to accurately portray the true cash position on a Cashflow Waterfall or Cashflow Statement.
Why is it important to get this right?
Ultimately, it is important to make a reasonable and accurate assessment of the Working Capital Adjustment as it allows assessment of whether cash in any given period will be sufficient for the business to operate, service liabilities and maintain or replace assets.