I invest in receivables (factoring) and I'm trying to determine what obligors are a good and not deteriorating credit risk. Part of this involves assessing obligors that are extending their days payable outstanding and the articles I've read indicate that this increases cash flow thereby allowing the firm to do more, buy more assets, make acquisitions etc.

So, I think working capital is defined as current assets minus current liabilities. In the example on this page: http://www.investinganswers.com/financial-dictionary/financial-statement-analysis/working-capital-869

WC = $95k

The article says that positive WC means a company can pay off their short term liabilities. That seems to me to mean the more positive WC the more a firm increases their cash flow

If the company extends the time frame to pay their accounts payable by a month, then I think their current liabilities will increase. This is because payables that would have been paid last month and removed from current liabilities will still be there. So working capital will go down because Current Assets - Current Liabilities will be a smaller number. I think that means deteriorated cash flow.

Assuming I have that part correct, here is my question. In this article http://www.scdigest.com/ontarget/13-05-02-1.php?cid=7006

In the 4th paragraph it says that by extending their payment terms, P&G is "reduc[ing] working capital, and therefore improv[ing] cash flow."

The word 'Reduce' seems to me should say 'Increase'. I.e. by increasing working capital they are increasing cash flow. Am I missing something? I'm not an accountant or financial analyst so I'm interested in the view of someone that is familiar with the topic.

Thanks in advance for your help.

  • edited to incorporate the personal investing angle. Is there an accounting board on StackExchange? – mchac Sep 10 '14 at 12:33

As you say, if you delay paying your bills, your liabilities will increase. Like say your bills total $10,000 per month. If you normally pay after 30 days, then your short-term liabilities will be $10,000. If you stretch that out to pay after 60 days, then you will be carrying two months worth of bills as a short-term liability, or $20,000. Your liabilities go up.

Assume you keep the same amount of cash on hand after you stretch out your payments like this as you did before. Now your liabilities are higher but your assets are the same, so your working capital goes down. For example, suppose you kept $25,000 in the bank before this change and you still keep $30,000 after. Then before your working capital was $25,000 minus $10,000, or $15,000. After it is $25,000 minus $20,000, or only $5,000.

So how does this relate to cash flow? While presumably if the company has $10,000 per month in bills, and their bank balance remains at $25,000 month after month, then they must have $10,000 per month in income that's going to pay those bills, or the bank balance would be going down.

So now if they DON'T pay that $10,000 in bills this month, but the bank account doesn't go up by $10,000, then they must have spent the $10,000 on something else. That is, they have converted that money from an on-going balance into cash flow.

Note that this is a one-time trick. If you stretch out your payment time from 30 days to 60 days, then you are now carrying 2 months worth of bills on your books instead of 1. So the first month that you do this -- if you did it all at once for all your bills -- you would just not pay any bills that month. But then you would have to resume paying the bills the next month. It's not like you're adding $10,000 to your cash flow every month. You're adding $10,000 to your cash flow the month that you make the change. Then you return to equilibrium. To increase your cash flow every month this way, you would have to continually increase the time it takes you to pay your bills: 30 days this month, 45 days the next, 60 the next, then 75, 90, etc. Pretty soon your bills are 20 years past due and no one wants to do business with you any more. Normally people see an action like this as an emergency measure to get over a short-term cash crunch. Adopting it as a long-term policy seems very short-sighted to me, creating a long-term relationship problem with your suppliers in exchange for a one-shot gain. But then, I'm not a big corporate finance officer.

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  • Ok, that's it. I hadn't considered they are increasing cash by withholding spending. Since you haven't paid the payable you have increased cash or you have deployed that cash into something else. A firm like P&G with an $50bn annual procurement spend extending DPO by 30 days will generate 1/12th of that $50bn or ~$4bn. Assuming they push out the DPO with half of their suppliers that's $2bn as mentioned in the article. – mchac Sep 10 '14 at 12:43

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