Working capital structures and components of two companies

Working capital provides an important indication of a firm's short-term financial health. Calculated as the difference between current assets and current liabilities, working capital tells whether an organization is able to cover its short-term liabilities (Sagner, 2010). If current liabilities exceed current assets, then it means a firm may have difficulty meeting its financial obligations in the next 12 months. Firms avoid such a scenario by effectively managing cash flow, cash balances, inventory, accounts payable, and accounts receivable. In this paper, the working capital structures of two companies are compared: Costco Wholesale Corporation (Costco) and Microsoft Corporation (Microsoft). The former is a retailer while the latter is a technology firm.

Working capital has three major components: accounts receivable, inventory, and accounts payable (Sagner, 2010). Accounts receivable are part of the company's current assets. They basically denote cash the company expects to receive in the short-term as a result of products or services delivered to a customer. Accounts payable on the other hand are part of the company's current liabilities. They refer to the money the company owes its suppliers. Accounts payable may also include money owed to lenders. Inventory denotes the goods a company holds at a given point in time.

For the two selected companies, this analysis focuses on the companies' latest annual reports (2016). In the period in question, the two companies recorded the following figures as far as working capital is concerned.

Item

Costco

Microsoft

Accounts receivable ($ millions)

1,252

18,277

Inventory ($ millions)

8,969

2,251

Cash, cash equivalents, and short-term investments

4,729

113,240

Total current assets ($ millions)

15,218

139,660

Accounts payable ($ millions)

7,612

6,898

Short-term debt

1,100

12,904

Total current liabilities ($ millions)

15,575

59,357

Working capital (Total current assets -- Total current liabilities) ($ millions)

-357

80,303

Working capital ratio (Total current assets / Total current liabilities)

0.98

2.35

Sources: Costco (2016), Microsoft (2016)

The above table reveals significant differences between the two firms' working capital, though the components are basically the same. First, Costco has a significantly larger component of inventory compared to Microsoft. For Costco, inventory comprises nearly 60% of its total current assets. However, Microsoft's inventory comprises less than 2% of the firm's total current assets. This difference can be attributed to the fact that the two firms operate in totally different industries. Indeed, the industry of operation usually affects working capital (Sagner, 2010). While Costco is a retailer, Microsoft is a technology firm. For retailers, holding huge amounts of inventory is common as retailers deal with merchandise. This is different for Microsoft and other technology services firms as they do not have to retain large amounts of physical inventory. Since Costco has a lot of current assets tied up in inventory, its ability to settle short-term financial obligations is diminished.

For both companies, accounts receivable do not comprise a significant proportion of total current assets: approximately 8% for Costco and 13% for Microsoft. This could be an indication of effective collection of receivables. As for accounts payable, Costco's accounts payable comprise nearly 50% of its current liabilities or current assets, while Microsoft's accounts payable constitute only about 12% of its current liabilities or 5% of its current assets. This implies that Microsoft is better placed than Costco to settle its short-term accounts payable using current assets. Even so, Costco has a better proportion of short-term debt to current liabilities (7%) compared to Microsoft (22%).

Overall, Costco has a working capital deficit or a working capital ratio of less than 1, meaning that its total current liabilities exceed its total current assets. As a result, the firm may not be able to fully meet its financial obligations in the next one financial year. Microsoft on the other hand depicts a substantial working capital surplus, with its current assets being more than double its current liabilities. Though Costco's working capital may not raise concerns about bankruptcy in the near future, especially because the firm has recorded increased sales in the last three years, it is imperative for the firm to improve its working capital. One thing that affected Costco's working capital in 2016 is a decline in its cash, cash equivalents, and short-term investments from $6.4 billion in 2015 to $4.7 billion in 2016 (Costco, 2016). During the same period, Microsoft recorded a significant increase in cash, cash equivalents, short-term investments, and current assets in general (Microsoft, 2016).

Costco can improve its working capital conditions by enhancing inventory management and changing its accounts payable policy. This would specifically involve minimizing inventory (for instance by adopting the just-in-time approach) and avoiding the payment of accounts payable early (for instance choosing financing options with longer repayment periods) (Sagner, 2010). Though Microsoft is doing well in terms of working capital management, there is still room for improvement. The firm has huge amounts of cash, which could be an indication of poor utilization of cash to generate income. Accordingly, the firm should avoid holding excessive amounts of cash. Microsoft also needs to enhance the management of its accounts receivable. This can be achieved by revising its credit policy (Sagner, 2010).

For an investor, the best company to invest in is Microsoft. Compared to Costco, Microsoft has a much stronger short-term financial health. This means that the investor would less likely be worried about the firm going bankrupt in the short-term. When picking a company to invest in, investors are usually concerned about the firm's ability to meet its short-term obligations (Sagner, 2010). Microsoft is better than Costco on this measure. Microsoft is also more attractive for a lender than Costco. A lender would be particularly concerned about the firm's current debt, current assets, and current liabilities (Sagner, 2010). Though Costco has low debt, its current liabilities exceed its current assets, meaning that a lender would be concerned about the firm's ability to settle short-term debt.

References

Costco Wholesale Corporation. (2016). Annual Report 2016. Retrieved from http://phx.corporate-ir.net/phoenix.zhtml?c=83830&p=irol-reportsannual

Microsoft Corporation. (2016). Annual Report 2016. Retrieved from https://www.microsoft.com/investor/reports/ar16/index.html

Sagner, J. (2010). Essentials of working capital management. Hoboken: John Wiley & Sons.