What is Working Capital?
One of the most important numbers on a companies balance sheet is known as working capital and it is simply calculated with the following formula: Current Assets - Current Liabilities. Working capital describes the financial strength of a company on the short run; it describes their cash position after cashing out all short term assets and paying off short term liabilities. Strong companies, like Microsoft, will have a significant cash position at their disposable during periods of slow economic activity.
It is important to emphasize that this calculation is performed by measuring short term assets as opposed to fixed, long term assets. It is much easier to cash out of money market accounts or savings accounts as opposed to selling manufacturing equipment. Cash strapped companies are more prone to taking high interest bank loans and issuing high yielding bonds.
It is also important to note that this number needs to be used in the appropriate context. Different types of businesses will have different standards when it comes to defining a "norm" for working capital. Companies exhibiting high inventory turnover ratios, such as grocery stores, have no need for keeping large sums of cash aside as they are consistently generating cash and can save it rather quickly if the need arises. Conversely, natural gas exploration companies will have a heightened need to stockpile reserves for a rainy day. When they strike a find, they are handsomely rewarded; however, they may go on a dry spell for months and even longer. For the long term health of companies with low inventory turnover, it is essential to have significant reserves to avoid taking high interest loans which could cripple the bottom line of a company and worse yet, lead to bankrupcy if there is no money to be found.
When digging into the financials of a company, always be sure to review the trend of the working capital ratio. A decline in this ratio over an extended period of time may be indicating a slow death for a company and should at least raise the yellow flag. Low levels of working capital can also indicate the companies inability to collect on their accounts receivables. This is more of a sign of incompetent management who is willing to extend a line of credit to even the riskiest borrowers, time and time again.