Working capital is more reliable than almost any other financial ratio or balance sheet calculation because it tells you what would be left if a company took all of its short-term resources and used them to pay off all of its short-term liabilities. All things being equal, the more working capital a business has available, the less financial stress it experiences.
However, a company that has too much working capital on hand can reduce its returns. An investor might have been better off if the board of directors decided to distribute some of that surplus in the form of dividends or share buybacks. It can be a complicated evaluation.
How to calculate working capital
Working capital is the easiest of all the balance sheet formulas to calculate. Here is the formula you will need:
Current assets – Current liabilities = Working capital
For example, suppose a company has $500,000 in cash on hand. Another $250,000 is outstanding and owed to the company in the form of accounts receivable. You have $1 million in inventory and physical property assets. Therefore, your current assets are $1.75 million.
Now let’s look at the company’s liabilities. You owe $400,000 in accounts payable, $50,000 in short-term debt, and $100,000 in accrued liabilities. Therefore, your current liabilities are $550,000.
Subtracting the company’s current liabilities from its current assets gives us a working capital of $1.2 million. That’s very good unless it’s a decrease from last quarter.
A company’s current ratio is calculated using the same elements as working capital.
Because it is important
A business in good financial shape should have enough working capital on hand to pay all of its bills for a year. You can tell if a company has the resources to expand internally or if it will need to turn to a bank or financial markets to raise additional funds by studying its working capital levels. The company in the above scenario is likely to be able to expand internally because it has the funds available.
One of the main advantages of analyzing a company’s working capital position is being able to anticipate many potential financial difficulties that may arise. Even a business with billions of dollars in fixed assets will quickly find itself in bankruptcy court if it can’t pay its bills when they are due.
Under the best of circumstances, insufficient levels of working capital can put financial pressure on a company, increasing its loans and the number of late payments made to creditors and suppliers. All of this can ultimately lead to a lower corporate credit rating. A lower credit rating means banks and the bond market will demand higher interest rates, which can cost a corporation a lot of money over time as the cost of capital rises and less income reaches the bottom line.
Negative working capital
Negative working capital on a balance sheet typically means that a business is not liquid enough to pay its bills for the next 12 months and also to sustain growth. But negative working capital can be a good thing for some high-performing companies.
Businesses that enjoy high inventory turnover and do cash business, such as grocery stores or discount retailers, require very little working capital. These types of businesses raise money every time they open their doors. They then turn around and invest that money in additional inventory to increase sales.
Because cash is generated so quickly, management can simply accumulate revenue from their daily sales over a short period. This makes it unnecessary to have large amounts of networking capital on hand in the event of a financial crisis.
A capital-intensive business such as a company responsible for manufacturing heavy machinery is a completely different story. These types of companies sell expensive items with long-term payments, so they can’t get cash as quickly.
Inventory on the balance sheet of this type of business is typically ordered months in advance, so it can rarely be sold quickly enough to raise capital for a short-term financial crisis. It might well be too late by the time it can be sold. These types of businesses can find it difficult to keep enough working capital on hand to overcome any unforeseen difficulties.