To a degree, this issue is exposed in the Working Capital magnitude. Case 1 features Working Capital of $10 million; Case 2 only $6 million. Yet this ignores the question of how much Working Capital you really need. That is driven by sales volume over time. For a small company, $6 million might be adequate and $10 million too much. For a large company, $10 million might be too little.

Days of Working Capital = Working Capital / (Sales/365)

This issue is addressed in "Days of Working Capital", defined as Working Capital / (Sales/365), or more simply, the number of days we could operate before our Working Capital would be consumed. You get 50 points if your Days of Working Capital falls between 30 days and 90 days.

In the example above, where sales are $100 million per year, Case 1 features 36.5 Days of Working Capital. That is a bit on the thin side, but within acceptable limits. Case 2 is too thin at 21.9 Days of Working Capital.

CASE 3
ASSETS ($000)				LIABILITIES & OWNER'S EQUITY
Current Assets				Liabilities
Cash	$0			Accts Payable		$6,000
Accts Receivable	$7,000			Current Debt		$4,500
Inventories	$14,000			Current Liabilities			$10,500
Current Assets		$21,000
Current Ratio	2.0			Days of Working Capital			38.3

Case 3 is a variation on Case 1. It illustrates what can happen when you start with thin reserves. There are 38.3 Days of Working Capital, and the Current Ratio is 2.0. Things look okay, but notice that you have no Cash. Our sales forecast was too optimistic. Inventory accumulated beyond our worst case, consuming all of our Cash. We were forced to take an Emergency Loan from Big Al. While one could argue that the problem here was forecasting, we were forecasting in an environment where we were tight for Working Capital. A small error resulted in disaster.

To summarize, your Working Capital position is the consequence of a set of policy decisions.

• What is the minimum Current Assets we require?
  
• What is the maximum Current Assets we will accept?
  
• How will we fund Current Assets, with debt or equity?

The equity portion is your Working Capital. These policy decisions can be evaluated with the Current Ratio and Days of Working Capital.