How to Calculate Working Capital on the Balance Sheet

Investing Lesson 3 - Analyzing a Balance Sheet

Working Capital on the Balance Sheet
Working capital is one of the most important financial ratios you can calculate from the balance sheet because it gives you an idea of the liquidity condition, and thus risk and efficiency, of an enterprise.. ra-photos / E+ / Getty Images

One of the main reasons serious investors look at a balance sheet is to discover a company's working capital (or "current position"). Working capital reveals more about the financial condition of a business than almost any other 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 its short-term liabilities. All else equal, the more working capital a firm has on hand, the less financial strain a company experiences.

By studying a company's current position, you can see if it has the resources necessary to expand internally or if it will need to turn to a bank or financial markets to raise additional funds.

How to Calculate Working Capital from a Balance Sheet

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

Current Assets - Current Liabilities = Working Capital

One of the main advantages of looking at the working capital position is being able to foresee many potential financial difficulties that may arise. Even a business that has billions of dollars in fixed assets will quickly find itself in bankruptcy court if it can't pay its bills when they come due. Under the best circumstances, poor working capital leads to financial pressure on a company, increased borrowing, and late payments to creditors and vendors - all of which result in a lower corporate credit rating.

A lower credit rating means banks and the bond market 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.

Negative Working Capital on the Balance Sheet Can Be a Good Thing for High-Turn Businesses

Companies that enjoy high inventory turns and do business on a cash basis (such as a grocery store or discount retailer) need very little working capital.

These types of businesses raise money every time they open their doors, then turn around and plow that money back into inventory to increase sales. Since cash is generated so quickly (often from a source known as vendor financing), management can simply stockpile the proceeds from their daily sales for a short period of time if a financial crisis arises. This makes it unnecessary to keep large amounts of net working capital on hand.

In contrast, a capital-intensive firm, such as a company responsible for manufacturing heavy machinery, is a completely different story. Because these types of businesses are selling expensive items on a long-term payment basis, they can't raise cash as quickly. Since the inventory on their balance sheet is normally ordered months in advance, it can rarely be sold fast enough to raise capital for short-term financial crises (by the time it is sold, it may be too late). It's easy to see why companies such as this must keep enough working capital on hand to get through any unforeseen difficulties.

Next page > Working Capital Per Dollar of Sales > <<back, 8, 9, 10, 11, 12, 13, 14, more >>

This page is part of Investing Lesson 3 - Understanding the Balance Sheet. To go back to the beginning, see the Table of Contents. If you have already read this lesson, you can skip directly to the Balance Sheet Quiz.

Continue Reading...