Working Capital

Working capital represents the capital that is tied up in day to day operations of a company. Net working capital equals the difference between the current assets and current liabilities, the working capital ratio equals current assets divided by current liabilities and working capital turnover equals net sales divided by average net working capital. A company must strike a balance between working capital turnover ratio and working capital ratio (also called current ratio).

A company’s assets and its liabilities are broadly classified into two categories: current and non-current. Current assets and liabilities are those which can are expected to be liquidated or settled within one operating cycle. It is important for a company to match the cash it generates from current assets with the cash it needs to settle current liabilities which makes the comparison of current assets with current liabilities very meaningful. Net working capital and the associated ratios just do that.

Net working capital

Working capital is an absolute figure i.e. an amount and not a ratio which can be calculated as follows:

$$ Net\ Working\ Capital\ =\ Current\ Assets\ – Current Liabilities $$

If you don’t have a balance sheet which classifies assets and liabilities into current and non-current, it helps to know that currents asset typically includes cash and cash equivalents, accounts receivable, inventories and prepayments while current liabilities include accounts payable, unearned revenue, taxes payable and accrued expenses.

Net working capital should be positive because it shows that the company is expected to receive more cash inflows than the cash outflows it is required to make in next twelve months. It communicates that the company has good liquidity position.

Working capital ratio

Working capital ratio is the ratio of current assets divided by current liabilities. It is more commonly referred to as current ratio. It is calculated using the following formula:

$$ Working\ Capital\ Ratio=\frac{Current\ Assets}{Curent\ Liabilities} $$

A working capital ratio (current ratio) higher than 1 is good because it tells there are sufficient current assets to pay off current liabilities. When the net working capital is positive, the current ratio is higher than 1 and vice versa.

Working capital turnover ratio

The relationship between net working capital and net sales can be studied to analyze a company’s efficiency.

The working capital turnover ratio calculates dollars of net revenue generates per dollar of net working capital. It is calculated by dividing net revenue by the average net working capital.

$$ Working\ Capital\ Turnover=\frac{Net\ Sales}{Average\ Working\ Capital} $$

Average net working capital is calculating by summing up the net working capital at the start of the year and at the end of the year and dividing it by 2.

A high working capital turnover is good because it shows that the company is generating more revenue per $1 of investment.

Analysis

A company must strike a trade-off between the net working capital balance (i.e. working capital ratio) and the working capital turnover ratio.

The current ratio tells us about the liquidity position. A high net working capital value and high current ratio show good liquidity position, but it also results in lower net working capital turnover ratio. A company must keep its current ratio such that it can easily pay off its current liabilities. However, current assets must not be too high relative to current liabilities so as to reduce working capital turnover which is a measure of a company’s asset utilization efficiency.

Negative working capital

In most cases, negative working capital value is bad because it tells that there are not enough current assets to pay off current liabilities. However, there are companies such as Walmart, etc. which are in such a strategic position that they can afford to work with their supplier’s capital. They can afford to have a negative net working capital. Their creditworthiness and market position are such that their suppliers offer very generous credit terms and are happy even if Walmart pays them only when the associated inventories and accounts receivables are converted to cash.

Written by Obaidullah Jan, ACA, CFA and last modified on