Personal Working Capital

A lot of people often overlook this aspect of finance in their own lives, and may assume that it’s a business concept and irrelevant in personal finance. However, this article intends to shed some light on how this powerful concept can be applied to your own life.

From a business perspective, it’s essentially the difference between short-term assets and short-term liabilities. It indicates how efficient a business is with its operations, specifically its payment cycle, as well as its financial health over the short-term.

Working capital is closely watched by a business since it provides an indication as to whether the company has enough liquid assets at hand to cover its short-term debt.

Too much working capital is a sign that the company isn’t using its excess short-term assets efficiently, while too little calls into question the ability for the company to meet its short-term debt obligations.

Interestingly enough, an individual shares many characteristics of a business. Both own assets and have liabilities, and both make income and have expenses.

Since all of these factors are used in managing working capital for a business, it’s quite easy to apply the concept to an individual.

A Classic Monthly Cycle

The individual who earns a monthly salary is acutely aware of the cash flow cycle of the month. Such as when their debit orders go off, when they do a “big” grocery shop, fill up with petrol and so on.

They try ensure that these regular expenses are matched by an equal salary at minimum, and perform the monetary gymnastics required to ensure they have enough money available at the right time.

A Month On Debit

In order to illustrate the concept of personal working capital, let’s look at a hypothetical individual who earns R20,000 each month (paid at the end of the month), and has a bank account that earns 5% simple interest per year.

For simplicity, let’s also assume that this individual’s only expenses occur at the end of every week and are constant at R5,000 per week. The monthly (four weeks) cash flow would look something like this.

Expenses on debit monthly cash flow

At the end of the month the individual would have made R48.08 interest, they would be paid their salary and then the cycle starts again the next month.

A Month On Credit

Before we delve into the mechanics behind personal working capital, let me state categorically that the use of credit requires discipline.

If the use of credit is not controlled it can lead to financial distress. When used appropriately however, it can unlock significant benefits.

Most credit card providers offer an interest free period of between 30 to 50 days, and it’s this aspect that we’re going to take advantage of. If your credit card does not offer an interest free period you can still apply the concept of personal working capital, but the benefits you receive won’t be as significant. It depends on the interest rate the credit card company charges.

Back to our example. Instead of the individual funding their expenses with money from their bank account, they’ll use their credit card instead. Their salary will still go into their bank account, but it won’t be used to pay for expenses and will become the personal working capital.

The salary received at the end of the month will then be used to pay off their credit card for the month, while the money that has been sitting in the bank will remain and earn interest. The cash flow is below.

Expenses on credit monthly cash flow bank account illustration

The Intricacies of Personal Working Capital

With this simple example it’s plain to see the benefit that comes when you make buying on credit work for you. The individual who didn’t employ the personal working capital technique made R48.08 interest income, while the individual who employed this technique made R76.92 interest income. That’s over one and a half times more.

The example was also very simplistic in the use of a bank account as the vehicle that holds the working capital. In reality there are arguably no transactional bank accounts that offer 5% interest.

Since the working capital should theoretically never leave the account it’s sitting in, it makes sense to invest it in a liquid asset with appropriate risk characteristics.

The asset should be liquid because working capital, by definition, is based on money that is quickly and easily available to access. So it wouldn’t be appropriate to invest the working capital in an asset (or account) that takes time to access.

As rule of thumb, if it takes any longer than five days to access the money, it is not an appropriate investment for personal working capital.

The asset should also carry extremely low, near zero, risk. This is because there may come a time when, for whatever reason, the monthly salary that’s used to pay off the credit card each month stops. You’ll then need to access the working capital in order to pay off your last month’s credit card bill.

If the asset the personal working capital is invested in carries inappropriately high risk, and the amount initially invested has decreased, you may find yourself in a tight spot and unable to cover the full bill.

You can find further information on risk characteristics of the general asset classes here.

Sneaky Fees

Those of you who have considered this technique up to this point may be asking yourself how the various bank account and credit card fees affect the bottom line. While I can’t speak for each company’s fees individually, I can provide some guidance.

To be frank, there’s a sweet spot. A break-even point if you will. This occurs when the interest that you make on your invested capital exactly equals the various fees for the month. If you’re considering this technique and want to get an idea whether it’s feasible for you before committing to a credit card. A quick “back of a napkin” calculation is as follows:

If: (monthly bank fees + monthly credit card fees) divided by (monthly personal working capital) multiplied by 12 then multiplied by 100

Is: less than the expected annual return of the working capital investment

Then: you’ll benefit.

A realistic example can be done using bank fees and credit card fees of R60 a month each, so R120 in total. Applying that to R20,000 working capital would look like this:

(60 + 60) / 20 000 x 12 x 100 = 7.20%

So in order to benefit from this technique you would need to invest the working capital in an investment that returns at least 7.20% per year.

In order to lower the required return you could either try decrease the fees through thorough research, or increase the amount of working capital you use monthly. The former is generally easier than the latter, and you shouldn’t try spend more each month just to make this technique work for you.

Ironically, even if you can’t make the required return to cover the monthly fees, you could still benefit somewhat from this technique. This can be illustrated using the same example.

In the first instance, an individual has a bank account with a monthly fee of R60 and R20,000 expenses a month, they do not use a credit card and expenses come off their bank balance. Their bank account also does not pay any interest. Thus, their monthly fee is R60.

In the second instance, the same individual uses a credit card with a monthly fee of R60 and still has the bank account with a monthly fee of R60. So R120 in total. They invest the working capital in an investment returning 6% interest per year. This is R100 interest per month (6% x 20 000 / 12). Thus, their net fee is R20 (R120 – R100).

Even though the individual added a credit card with a monthly fee, and couldn’t invest the working capital at the required return to break-even, they were still better off by reducing their net monthly account fees from R60 to R20.

In Summary

While this technique is powerful, it is a hands on approach and requires the following:

  • Using a credit card that has an interest free period.
  • Being disciplined to not get carried away buying on credit.
  • Acutely aware of your monthly cash flow and their timings.
  • The choice of an appropriate asset to invest the working capital.
  • A double check to see if the net fee justifies using the technique

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