Working capital

Working capital is the amount of money a company needs to have on hand to pay its obligations in the short term. It is used to bridge utility finances between the time that expenditures are made and revenue is received from ratepayers to cover these costs. For example, a utility may purchase electricity in the market and deliver that power to customers immediately. But the customers that use the power may not pay for it until the following month. Working capital may also be required to meet expenditures such as quarterly dividend payments to shareholders or debt interest payments. 

The working capital allowance is typically calculated in one of two ways:

  1. Lead-lag study: This study measures the average number of days between when a company must pay its expenses and when related revenues are received. For example, suppose a company typically pays its expenses 25 days after they are incurred, but the company doesn’t receive payments until 45 days after a service has been provided. In this case the lag would be 20 days, and the working capital allowance would be calculated based on the amount of cash required to manage the 20-day lag. 

  2. Formulaic estimate: A simpler approach to calculating required working capital is to use a formula. For example, a utility’s average operating and maintenance (O&M) expenses over a period of time. In this case, the utility’s working capital might be set equal to 45 days’ O&M expenses. This is commonly calculated using the “one-eighth formula” where annual O&M expense is divided by eight.

For investor-owned utilities, a working capital allowance is included in rate base and thus earns a rate of return.