How to calculate normalized working capital

How to calculate working capital on the balance sheet

Analysis of a balance sheet: working capital

One of the main reasons serious and professional investors want to analyze a company's balance sheet is to be able to determine a company's working capital, or "current position". Working capital shows a lot about the financial situation or at least the short-term liquidity position of a company.

Working capital is more reliable than almost any other financial metric or balance sheet calculation because it tells you what would be left if a company took all of its short-term resources and used them to pay off all of its short-term liabilities.

When all else is equal, the more working capital a company has, the less financial burden it experiences.

But a company that has too much working capital can lower its earnings. An investor might have been better off if the Board of Directors had decided to distribute some of that excess in the form of dividends or share buybacks instead. It can be a difficult assessment.

How to calculate working capital from a balance sheet

Working capital is the simplest of all balance sheet invoices to be calculated. Here is the formula you will need:

Current assets - current liabilities = working capital

As simple as that.

For example, suppose a company has $ 500,000 in cash. Another $ 250,000 is outstanding and owed to the company in the form of accounts receivable. It has $ 1 million in inventory and physical real estate. The current assets are thus 1.75 million US dollars.

Now let's look at the company's liabilities.

It owes $ 400,000 in debt, $ 50,000 in current debt, and $ 100,000 in debt. The current liabilities are thus $ 550,000.

If you subtract the company's current liabilities from its current assets, you have working capital of $ 1.2 million. That’s very good.

The importance of working capital

By definition, a company should have sufficient working capital to pay all of its bills for a year.

You can tell if a company has the resources to expand internally, or if it needs to turn to a bank or financial markets for additional funding by measuring working capital. The company in the above scenario is likely able to expand internally as it has the funds available.

One of the main advantages of looking at a company's working capital position is the ability to identify many potential financial difficulties that could arise. Even a company with billions of dollars in fixed assets is quick to find itself in bankruptcy court if it can't pay the bills when they are due.

In the best of circumstances, insufficient working capital can put financial pressure on a business, increasing borrowing and late payments to creditors and sellers. All of this can ultimately lead to a lower credit rating for the company. A lower credit rating means banks and the bond market will charge higher interest rates, which can cost a company a ton of money over time as the cost of capital increases and less revenue makes it the bottom line.

Negative working capital on the balance sheet

Negative working capital on a balance sheet usually means that a company is not sufficiently liquid to pay its bills for the next 12 months and also to sustain growth.

But negative working capital can be a good thing for some high-turn companies.

Companies that have high levels of inventory and purchase in cash, such as grocery stores or discount stores, require very little working capital. These types of businesses raise money every time they open their doors. Then they turn around and plow the cash back into inventory to increase sales.

Because cash is generated so quickly, usually from a source known as credit financing, management can simply hold on to the proceeds from their daily sales for a short period of time. This makes it unnecessary to hold large amounts of net working capital in the event of a financial crisis.

A capital-intensive company like a company responsible for making heavy machinery is a whole different story.

These types of companies sell expensive items on a long term payment basis so they can't raise money as quickly. The stocks on their balance sheets are usually ordered months in advance, so they can rarely be sold fast enough to raise capital for a short-term financial crisis. It might be too late by the time it can be sold.

It's easy to see why companies like this need to have enough working capital to overcome unforeseen difficulties.