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Investment ABCs - What is Working Capital? - March 5th 2003



Because there are many accounting terms used in the investment community that you should be familiar with as an investor, I am starting a series of articles intended to highlight some important accounting issues and how they relate to the evaluation of stocks.

 

I'm sure at one point or another you have heard the term "working capital," however, like many other small investors, you might not have a clear understanding of what it is and its importance in evaluating the financial position of a company.

 

Working capital is calculated as follows:

 

Working Capital = Current Assets - Current Liabilities

 

The current assets and current liabilities figures can be found on the company's balance sheet. Current assets are comprised of cash, short-term deposits, liquid marketable securities, accounts receivable, inventory, and other assets which are expected to be or could easily be liquidated into cash within a period of one year or less. Current liabilities include short-term bank indebtedness (demand loan or line of credit), accounts payable, deposits received from customers for future delivery of products or services, taxes and payroll remittances payable to the government, and the portion of the company's long-term loans that will be repaid during the next 12 months. *** Working capital essentially measures the company's ability to discharge all of its short-term obligations (those coming due within the next 12 months) without relying much on operating cash flow.

 

*** Note that due to new regulations, companies have started to report the majority of long-term debt as a current liability. You may have to determine how much of this debt will need to be repaid in the current year to accurately determine true working capital.

 

If a company's working capital is negative, it generally means that it will need to rely on its operating cash flow, new bank loans, the expansion of its line of credit, or other external financing to pay all of its debts that are expected to come due during the next year. Negative working capital generally constrains a company's ability to grow, and if it is unable to generate significant operating cash flow or raise more expansion funding, it can sometimes be an early indicator of a company headed for failure through receivership or bankruptcy. Companies in a negative working capital position may become desperate for financing, at which point bankers and venture capitalists will demand attractive terms for additional investment. These terms are usually not positive for the company and its existing shareholders in that the new financing often results in heavy dilution or expensive interest costs. In a sense, the company starts working for the financier, not its shareholders. Of course, it has little choice - it must do so to survive.

 

If a company's working capital is positive and it is generating cash flow from its operations, it is generally well funded to meet its obligations for the coming year. The more working capital a company has, the more capacity it has to grow its business both through acquisition and internal measures, and to endure brief downturns in demand for its product,.

 

Working capital is often expressed as a ratio, aptly called the current ratio, which is calculated as follows:

 

Current Ratio = Current Assets / Current Liabilities

 

In general, a current ratio of 2 or higher is preferred. The higher, the better. A ratio of less than one can be cause for concern unless a subsequent financing has boosted the company's cash reserves. Additional examination would definitely be warranted. A ratio of between 1 and 2 can be acceptable for certain companies, especially those with strong earnings growth and fast receivables and inventory turnover (i.e. their customers pay quickly and their inventory doesn't sit on the shelf very long before being sold). To be even more conservative, many investors and analysts prefer to use the quick or "acid test" ratio as opposed to the current ratio. The quick ratio assumes that inventory can not be converted into cash quickly, because of product obsolescence, traditionally slow inventory turnover, or other reasons.

 

Quick (Acid Test) Ratio = (Current Assets - Inventory) / Current Liabilities

 

While standard benchmarks range from analyst to analyst and will vary depending upon the industry in which the company operates, most investors avoid companies with a quick ratio of less than 0.8.

 

As an analyst, working capital is usually the first thing I look for when I review a company's balance sheet. The importance of having a solid balance sheet will become increasingly important over the coming months as many small-cap companies are already finding it increasingly difficult to raise funding in the equity markets to support their operations. Those companies that have the financing already in place to expand their business will be in a far better position to grow than those that don't. Considering it only takes a few moments to calculate the current ratio and quick ratio for most companies, it is well worth the time to do it. It could save you from putting your money into a sinking ship.

 

Grant Robertson, B.B.A.

 

Disclaimer: The author is not a registered investment advisor. Accordingly, this article is presented for educational and information purposes only. Those seeking specific investment advice should consult a registered investment advisor. You are urged to consult your investment advisor before embarking on any new investment strategy as the strategies depicted in this article may not be suitable for all investors.

Canadian Small Caps

 
Canadian Small Caps

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