investing

What is working capital and how do you calculate it?

Businessmen discussing column graphs | iStock.com/shironosov

iStock.com/shironosov

Cash is what keeps a business ticking. How much liquidity a business keeps on hand compared with how much it needs -- and how efficiently capital is used -- are of great interest to investors.

To peek into the cash needs of a business, investors look at the balance sheet and calculate the level of working capital.

"Working capital is simply the total of a firm's current assets minus current liabilities," says Robert R. Johnson, president and CEO of The American College of Financial Services in Bryn Mawr, Pennsylvania.

"Basically, if a firm has positive working capital, that means it has enough short-term assets to cover its short-term debt," he says.

So once you've examined the working capital of a potential investment, what does it even mean to you, the investor?

"Every type of business -- depending upon its size, the nature of it -- its ratio analysis is most meaningful when it's compared to a similar business. When you say is this ratio good, bad or indifferent, the answer is, compared to what?" says Mark S. Gottlieb, CPA, owner of MSG, a forensic accounting and business valuation firm.

Working capital

Working capital equals a company's current assets minus current liabilities. Current assets include cash and assets that can be turned into cash within 1 year. Current liabilities are debts due within 1 year of the date of the financial statement.

How to measure working capital

And, of course, there is a ratio involved with working capital. You didn't think that anything involved with financial statement analysis simply required 1 little subtraction problem, did you? Pause for hysterical laughter, followed by tears.

At least this calculation is easy enough: Simply divide current assets by current liabilities to find the current ratio, a measure of liquidity.

The financials driving 2 car companies

Honda Motor Co.*
Total current assets$52,501,000
Total current liabilities/ $44,203,000
Current ratio1.188
Toyota Motor Corp.*
Total current assets$149,563,000
Total current liabilities/ $137,015,000
Current ratio1.092

On the surface, it appears that Honda was in better financial shape than Toyota in spring 2015, but there are other factors to consider, including the amount of cash in their current assets.

*As of March 31, 2015

"One rule of thumb is that a current ratio of greater than 1.25 indicates that the firm is in good short-term financial condition. The higher the current ratio, the more sound the short-term financial health," says Johnson.

And here's another formula: the working capital turnover ratio.

"Relating the level of sales arising from operations to the underlying working capital measures how efficiently working capital is employed," Gottlieb says.

Working capital turnover ratio

The basic equation goes like this: Net annual sales / average working capital.

The ratio tells investors how many times working capital is turned over in a year.

"A low ratio may indicate an inefficient use of working capital, while a very high ratio often signifies overtrading," says Gottlieb. In this context, overtrading means taking on more business than working capital can keep up with.

It's helpful to compare the working capital turnover ratio to that of other companies, and also to the company's use of capital in the past.

Investors also look at the quality of assets when assessing working capital. Not all assets are created equal.

As far as current assets go, cash is king, says Johnson, particularly compared with inventories.

Highly liquid investments are more helpful in a pinch than resources that would be difficult to sell and convert into cash.

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