What is Working Capital? Definition, Importance & More.
Hello Readers. One of the most important factors to check while analyzing a company before making an investment decision is its working capital.
In simple words, working capital can be defined as the funds available to a firm to finance its regular operations like day to day business activities. Nonetheless, the noteworthiness of working capital is way more than what most people think.
In today’s article, we will be focusing on the importance of working capital management and how it could be studied to get a deeper insight into the companies we are researching for potential investments.
Here are the topics that we’ll cover in this post.
- What is working capital?
- Why is working capital important?
- What factors affect the working capital of a company?
- When Negative net working capital is actually positive.
Overall, it’s going to a very educational post. Therefore, please read this article till the very end. Let’s get started.
1. What is working capital?
To define the term in the simplest words, working capital is essentially the funds that have been allocated for day to day operations of the firm for the current financial year. These funds need not entirely be held in cash but could also include any asset or liability from which a cash transaction could be expected. This could include account tradables, cash in hand, account payables and short-term borrowing and loans.
The most commonly used formula for working capital is given by the following,
Net Working Capital = Current Assets – Current Liabilities
When an investor wants to look only at the operating level of a company he may prefer to use the following formula for working capital.
Operating Working Capital = Cash + Inventory + Accounts Receivables – Accounts Payables
Please note that the operating working capital excludes the short-term interest and loan payments a company may have to incur in a financial year.
2. Why is working capital important?
Conventionally, the working capital is used as a measure of a company’s liquidity. Since it is calculated on the basis of accounts receivable/payable, cash, borrowing and payments, the working capital of a company could tell us a ton about the management’s approach and commitment to inventory management, debt management, revenue collection, and payments to suppliers.
A positive working capital would imply that a company has got a good control over its transactions and is able to collect and make payments with a large degree of freedom.
A negative working capital, on the other hand, would normally imply the opposite.
3. What factors affect the working capital of a company?
Although working capital is studied to get an understanding of the management and the general thumb rule that positive working capital is always better than negative working capital works most of the times in investing. We, at Trade Brains, believe that investors could get access to more opportunities if they were to take a more holistic approach to study working capital.
Since a company is always involved in a particular business, it is, therefore, logical to assume that all the short/long term factors affecting the industry will determine how managers conduct their operations and hence the working capital. In some industries, managers can offset the risk in operations by choosing a favorable business model. Depending on the kind of model they choose to operate could also determine the working capital of the company.
On a broad level, the list of factors that can affect the working capital of a company are as below (note that this is not exhaustive but may be used as a guide)
- Nature and type of business
- Type of Industry
- Factors of production and their availability
- Price levels and inflation
- Production Cycle Time
- Credit Policy and agreements with suppliers and customers
- Growth and Expansion strategies
- Working capital cycle
A more quantitative approach to analyzing working capital would be through a basic ratio analysis. Below are the most useful metrics used by fundamental investors.
4. When Negative net working capital is not so negative!
Imagine a newspaper printing and distribution company with around 2,000 customers in a city. When a customer signs up for a subscription for 1 year, he/she may have to pay the amount up front for the period for which the service is provided. Assume that the subscription cost for one year is ₹1,000, this implies that the company will receive ₹20,00,000 in advance payment. This amount is recorded under accounts payables portion of the balance sheet. Assume that the company holds another ₹8,00,000 in cash and an inventory worth ₹2,00,000. The net working capital of the company can then be computed to be -₹10,00,000.
In the above example, it can be noticed that even though the working capital happens to be negative the business model of the company allows the company to receive its cash well in advance. This cash could then be ploughed back into the business as investments into new equipment or into marketing to expand its client base.
In general, companies that have high inventory turns and perform a lot of business on a cash basis, such as grocery stores or discount retailers, require very little working capital. These types of businesses raise money every time they open their doors. Because of their advantages, these company can also enter into contracts with vendors and suppliers to lend their products for free for a specified period of time. These partnerships allow the retailers/discounters to keep their cash in hand and employ them elsewhere which trying to sell the products they got through credit. If they are unable to sell them they could just return it back to the vendors before the end of their negotiated period without any cost.
The following sectors are normally observed to operate with a negative working capital.
- Retail: Due to supplier agreements and high inventory turnover
- FMCG: Able to leverage their wide brand appeal and customer demand to get retailers to book their products in advance
- Automobiles: Companies employ “just in time” manufacturing policies to keep efficiency high and inventory at low levels. Also, they normally charge a decent sum as an advance from customers as booking charges.
- Media: Services are provided only after an upfront subscription fee
Although analyzing the working capital and its various components form an essential part of investment research. An investor should always keep in mind to view the company as a business and try to understand the root causes within the business model or the industry which drive the numbers.
Sticking to an individual’s circle of competence may help greatly in this regard which investing in stock markets. Happy Investing!
Levin is a former investment banker and a hedge fund analyst. He is an NIT Warangal graduate with around 5 years experience in the share market.