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Analysing a company or business should not only be restricted to sales and profits. One should always check how a business is managing its day-to-day operations, whether the company has enough capital to pay off its everyday bills, buy inventory, pay employees, and more. You must be wondering, how should I check the efficiency of the business? This is where working capital becomes important.
Working capital is the difference between a company’s assets and its current liabilities. A company can look profitable on paper but struggle to manage operations due to the unavailability of enough working capital.
Understand what working capital is, how it works, and more in this article.
Key Takeaways
- Working capital indicates a company's short-term financial health and its capacity to settle current liabilities using current assets.
- A company may be profitable but suffer cash-flow difficulties if funds are locked into inventory or accounts receivable.
- Effective management of cash, inventory, receivables, and payables can improve the company’s short-term liquidity and operational efficiency.
- Investors must look at the working capital trend in the past and compare it with other companies operating in the same industry.
- Working capital can be an important factor when analysing stocks, but it must be analysed along with profitability, leverage, cash flow, growth, and valuation.
How is Working Capital Calculated?
The working capital formula is:
Working Capital = Current Assets - Current Liabilities
Current assets are those assets that the business intends to turn into cash or consume within one year or a normal operating cycle. Current assets normally consist of cash, accounts receivable, inventories, and short-term investments.
Current liabilities are the liabilities that the business intends to settle within one year. Examples of current liabilities include accounts payable, short-term borrowings, salary payable, taxes, and other current liabilities.
Let us understand with an example, let’s say a company has current assets worth ₹15 lakh and current liabilities worth ₹10 lakh. Then, as per the above formula, the company has a positive working capital of ₹5 lakh.
₹15 lakh – ₹10 lakh = ₹5 lakh
But this doesn’t mean that the ₹5 lakh is lying in its bank account. Some of its current assets may be in inventories or accounts receivable.
Also Read About: What are Assets and Liabilities?
Types of Working Capital
- Gross Working Capital: Gross Working Capital is the total capital invested in current assets. It consists of current assets like cash, inventories, receivables, and marketable securities.
- Net Working Capital: Net Working Capital is the excess of current assets over current liabilities. Net Working Capital = Current Assets - Current Liabilities
- Permanent Working Capital: Permanent Working Capital is the least amount of Working Capital a business requires to run its operations normally. Even with changes in the volume of sales, a company still needs a minimum amount of cash, inventories, and other current assets for running its operations.
- Temporary Working Capital: Temporary Working Capital is the extra Working Capital needed due to seasonality, uncertainty, or any other temporary condition in the business. For instance, retailers might require higher inventories and cash just before the holiday shopping season.
Also Read About: What is Share Capital?
Positive and Negative Working Capital
Working capital is normally either positive, zero, or negative.
Positive Working Capital
A company has positive working capital when the total current assets exceed the current liabilities.
Having positive working capital normally provides more flexibility to a business in terms of dealing with short-term obligations.
On the other hand, extremely high working capital is not necessarily beneficial to a business. In this case, it might indicate that a business has excess inventory or takes too long to collect its receivables.
Negative Working Capital
Negative Working Capital arises in a situation where the current liabilities exceed current assets.
Let’s understand this with an example. Suppose a company has current assets of ₹8 lakh and current liabilities of ₹12 lakh. Its working capital would therefore be −₹4 lakh, indicating that its current liabilities exceed its current assets by ₹4 lakh.
In such a case, there is a possibility that a business will face challenges in meeting its short-term obligations.
Negative Working Capital is not necessarily a problem for all businesses. Some businesses get payments from their customers immediately but take longer to pay their suppliers. Therefore, working capital should be analysed based on the nature of the business.
Importance of Working Capital
Working capital is key since companies have to pay day-to-day bills irrespective of whether they receive payments from customers or not.
For instance, consider a company that manufactures furniture. It buys wood and other raw materials, manufactures the furniture, and then sells the furniture to the customers who pay some weeks later.
During this time, the company will still have bills to pay to its workers, suppliers, power bills, rental payments, and others. In case the company lacks sufficient working capital, it will experience cash flow problems.
Working capital management helps a company to:
- Pay its bills promptly
- Have enough inventory
- Pay workers and suppliers
- Manage any unforeseen expenses
- Take advantage of business opportunities
- Operate its day-to-day operations efficiently
- Reduce reliance on short-term borrowing
This is the reason why working capital is usually closely associated with the short-term financial condition of the company.
Also Read About: Liquidity Ratio
What is a Working Capital Cycle?
The working capital cycle is the time it takes for a business to turn its current assets and liabilities back into cash. A shorter cycle means the company gets its money quicker, making it easier to run the operations smoothly.
A company begins with cash, which it uses to buy inventory or raw materials. After that, it sells its products. In case of credit sales, accounts receivable is recorded by the firm. Once the customers pay, the money comes back to the firm as cash.
A longer Working Capital cycle indicates that an organisation requires more money to operate.
How to Use Working Capital for Selecting Stocks for Investment?
Working capital can help investors assess the efficiency of a company in managing its daily operations. It shouldn't be the sole factor that an investor uses to select a stock, but it can offer important clues about the financial health of a company.
Smart retail investors integrate working capital analysis into their fundamental stock screening checklist:
- Track 3 to 5-Year Trends: Examine whether working capital ratios are stabilizing, improving, or deteriorating. A prolonged decline warrants a deep dive into annual reports to check if cash is trapped in dead inventory.
- Compare sales growth with receivables: When sales grow much faster than cash collection, the company might be giving too much credit or struggling to collect money. Investors should look closely at collection trends and accounts receivable to understand the true financial health.
- Examine inventory buildup: If inventory grows faster than sales over consecutive quarters, it may indicate slower inventory movement or weaker demand.
- Cross-verify with operating cash flows: Comparing working capital trends with operating cash flow reveals how a company can report accounting profits while cash remains weak, often due to funds tied up in inventory and receivables.
Conclusion
Working capital measures a business's short-term liquidity to ensure it can sustain daily operations and meet upcoming debts. Rather than hoarding cash, effective management focuses on optimizing the continuous flow of funds through tight control over inventory, receivables, payables, and expenditures. Balancing these components efficiently prevents cash shortages and positions the company for sustainable growth.
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