Working Capital
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Working Capital
The number one reason most people look at a balance sheet is to find out a companys working capital (or “current”) position. It reveals more about the financial condition of a business than almost any other calculation. It tells you what would be left if a company raised all of its short term resources, and used them to pay off its short term liabilities. The more working capital, the less financial strain a company experiences. By studying a companys position, you can clearly see if it has the resources necessary to expand internally or if it will have to turn to a bank and take on debt.
Working Capital is the easiest of all the balance sheet calculations. Heres the formula:
Current Assets – Current Liabilities = Working Capital
One of the main advantages of looking at the working capital position is being able to foresee any 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 cant pay its monthly bills. Under the best circumstances, poor working capital leads to financial pressure on a company, increased borrowing, and late payments to creditor – all of which result in a lower credit rating. A lower credit rating means banks charge a higher interest rate, which can cost a corporation a lot of money over time.
Companies that have high inventory turns and do business on a cash basis (such as a grocery store) 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, managements can simply stock pile the proceeds from their daily sales for a short period of time if a financial crisis arises. Since cash can be raised so quickly, there is no need to have a large amount of working capital available.
A company that makes heavy machinery is a completely different story. Because these types of businesses are selling expensive items on a long-term payment basis, they cant 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 money for short-term financial crises (by the time it is sold, it may be too late). Its easy to see why companies such as this must keep enough working capital on hand to get through any unforeseen difficulties.
Working Capital per Dollar of Sales
To find the approximate amount of working capital a company should have, you should look at “working capital per dollar of sales.” In other words, you are going to have