Question

Why is working capital given special attention in the process of analyzing balance sheets? why is it important for business people to be aware of/know about this concept?

Answer 1

Working capital reveals a great deal about the financial condition, or at least the short-term liquidity position, of a business.

Working capital is more reliable than almost any other financial ratio or balance sheet calculation because it tells you what would remain if a company took all its short-term resources and used them to pay off all its short-term liabilities. All else being equal, the more working capital a company has on hand, the less financial strain it experiences.

But a company that keeps too much working capital can drag down 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 repurchases instead. It can be a tricky evaluation.

How to Calculate From a Balance Sheet

Working capital is the easiest of all the balance sheet calculations to calculate. Here's the formula you'll need:

Current assets - Current liabilities = Working capital

It's that simple.

Say 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. It has $1 million in inventory and physical property assets. Its current assets are therefore $1.75 million.

Now let's look at the company's liabilities. It owes $400,000 in accounts payable, $50,000 in short-term debt, and $100,000 in accrued liabilities. Its current liabilities are therefore $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.

Current ratio is calculated using the same elements as working capital.

Why It's Important

By definition, a company should have sufficient working capital on hand to pay all its bills for a year. You can tell if a company has the resources necessary to expand internally or if it will need to turn to a bank or financial markets to raise additional funds by studying working capital levels. The company in the above scenario is likely to be able to expand internally because it has the available funds.

One of the main advantages of looking at the working capital position of a company is being able to foresee many potential financial difficulties that might arise. Even a business with billions of dollars in fixed assets will quickly find itself in bankruptcy court if it can't pay the bills when they come due.

Under the best circumstances, insufficient levels of working capital can lead to financial pressures on a company, increasing borrowing and the numbers of late payments to creditors and vendors. 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 revenue makes it to the bottom line.

When It's Negative

Negative working capital on a balance sheet normally means a company is not sufficiently liquid to pay its bills for the next 12 months and to sustain growth as well. But negative working capital can actually be a good thing for some high-turn businesses.

Companies that enjoy high inventory turns and do business on a cash basis, 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 plow that money back into inventory to increase sales.

Because cash is generated so quickly, usually from a source known as vendor financing, management can simply stockpile the proceeds from their daily sales for a short period of time. This makes it unnecessary to keep large amounts of net working capital on hand in case a financial crisis arises.

A capital-intensive firm such as a company responsible for manufacturing heavy machinery is a completely different story. These types of businesses are selling expensive items on a long-term-payment basis so they can't raise cash as quickly. The inventory on their balance sheets is normally ordered months in advance so it can rarely be sold fast enough to raise capital for a short-term financial crisis. It might well be too late by the time it can be sold.

These companies might have difficulty keeping enough working capital on hand to get through any unforeseen difficulties.