Working capital is the money that remains if you subtract a company's current liabilities from its current assets. All else being equal, the more working capital a company has on hand, the less financial strain it experiences.
However, a company that keeps too much working capital on hand isn't using its working capital efficiently. Learn what working capital is, how to calculate it, and how to use it to interpret a stock issuer's short-term liquidity.
Definition and Examples of Working Capital
Working capital is the money a business would have leftover if it were to pay all its current liabilities with its current assets. Current liabilities are debts that are due within one year or one operating cycle. Current assets are assets that a company plans to use over the same period.
Examples of current liabilities are accounts payable, short-term loans, payroll taxes payable, and income taxes payable. Any account that is payable within a year or operating cycle is a current liability.
Some current asset examples are cash, accounts receivable, investments that can be liquidated, and inventory. In general, similar companies in similar industries don't always account for both current assets and liabilities the same internally or on their financial reports.
When looking at company financials, it's easy to become confused over assets and liabilities. Look for the word "current" in front of the asset or liability.
Similar businesses may have different amounts of working capital and still perform very well. It's also possible to have negative working capital and perform well. Therefore, working capital should be taken in the context of the industry and financial structure of the company you're evaluating.
How Do You Calculate Working Capital?
Businesses keep accounting records and aggregate their financial data on financial reports. To find the information you need to calculate working capital, you'll need the company's balance sheet. Current assets and liabilities are both common balance sheet entries, so you shouldn't need to do any other calculating or assuming.
Working capital is straightforward to calculate. The formula is:
How To Interpret Working Capital
A company in good financial shape should have sufficient working capital on hand to pay its bills for one 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 investors to raise additional funds by studying its working capital.
One of the main advantages of looking at a company's working capital position is the ability to foresee any financial difficulties. 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 come due.
Under the best circumstances, insufficient working capital levels can lead to financial pressures on a company, which will increase its borrowing and the number of late payments made to creditors and vendors.
All of this can ultimately lead to a lower corporate credit rating and less investor interest. A lower credit rating means banks and the bond market will demand higher interest rates, reducing revenue as the cost of capital rises.
Negative Working Capital
Negative working capital on a balance sheet typically means a company is not sufficiently liquid to pay its bills for the next 12 months and sustain growth. However, companies that enjoy a high inventory turnover and do business on a cash basis require very little working capital.
Negative working capital can be a good thing for businesses that have high inventory turnover.
Examples of these types of businesses are grocery stores and discount retailers. In general, they raise money every time they open their doors by selling inventory. Then, they use that money to purchase more merchandise.
Because cash generates so quickly, management can stockpile the proceeds from its daily sales for a short period. This makes it unnecessary to keep large amounts of net working capital on hand to deal with a financial crisis.
Limitations of Using Working Capital
While an excellent tool for determining how much wriggle room a company has financially, working capital has limitations. A capital-intensive firm such as a heavy machinery manufacturer is an excellent example.
These businesses specialize in expensive items that take a long time to assemble and sell, so they can't raise cash quickly from inventory. They have a very high number of fixed assets that cannot be liquidated and expensive equipment that caters to a specific market.
Large manufacturers that have been in operating for some time generally have more working capital than younger ones.
The inventory on the balance sheet for this type of company is usually ordered months in advance—it can rarely be purchased and used to manufacture equipment fast enough to raise capital for a short-term financial crisis. It might well be too late by the time it is sold. These companies might have difficulty keeping enough working capital on hand to get through any unforeseen problems.
As with all financial analysis ratios and formulas, you should use them to build a holistic picture of the value of an investment. One company's working capital will be different from another similar company, so comparing them may not be ideal for using the concept.
Industry averages are also good to use, but they are not always a reliable indicator of the financial abilities of a business. You should use the information gained to evaluate a company compared to your investing strategy and goals.
- Working capital is the amount of money a company has left over after subtracting current liabilities from current assets.
- Working capital tells you if a company can pay its short-term debts and have money left over for operations and growth.
- Working capital should be used in conjunction with other financial analysis formulas, not by itself.