A company's revenue affects various working capital accounts, which include inventory, accounts receivable and accounts payable. Revenue increases may have a positive or negative effect on working capital accounts depending on how quickly the company converts sales into cash or current assets to support its current liabilities.
Working capital is equal to current assets less current liabilities. A company with positive working capital has enough short-term assets to pay off its current liabilities. A company with a negative working capital position cannot meet its short-term obligations with its current assets. Working capital ratios measure management's operating efficiency. Two ratios that utilize working capital accounts include the current ratio (current assets / current liabilities) and quick ratio ([current assets minus inventories] / current liabilities). A ratio greater than 1 is a good indication of the company's ability to manage short-term financial obligations.
The point in time when a company records a sale impacts its working capital accounts. For example, a company records a sale and funds from the sale immediately in an all-cash business. However, in many instances, revenue recognition does not lead to an immediate influx of cash but rather an accounts receivable, which is a short-term asset.
Working Capital Management
In general, increases in revenue lead to higher accounts receivables, depleting inventories, and possibly higher accounts payable. As the company sells more products, it uses its available inventory. Increases and decreases in accounts payable relate how the company uses short-term financing to fund its operations. An increase in accounts payable indicates company use of vendor financing to finance ongoing operations. Ideally, as the company collects money from its accounts receivable, it uses the proceeds to pay down accounts payable.
Merely looking at the effects of increasing or decreasing revenue on working capital is not enough. An analyst must dig deeper into the individual accounts to discover the physical makeup of working capital, which is an indication of the financial health and strength of the company. For example, even though inventory is a current asset, it may be of low quality. Higher inventory level coupled with a declining sales rate may be an indication of outdated inventory. The company may have to offer discounts to customers to rid itself of unwanted merchandise, which puts a squeeze on profit margins. In addition, higher levels of accounts payable coupled with lower levels of accounts receivable is a sign that the company is too reliant on vendor financing or is unable to pay vendors on time. Higher receivables may be an indication that the company is having trouble collecting from its customers.