Companies with high amounts of working capital possess sufficient liquid funds needed to meet their short-term obligations. Working capital, also called “net working capital,” is a liquidity metric used in corporate finance to assess a business’ operational efficiency. It is calculated by subtracting a company’s current liabilities from its current assets.
Current assets are considered to be extremely liquid if they are able to be converted to cash within a calendar year. Typically, the current asset category on a company’s balance sheet includes the following items:
- The value of any cash on hand
- Checking and savings accounts
- Marketable securities like stocks, bonds, and mutual funds
- Any inventory a company plans to sell within one year
- Accounts receivables, which are debts owed by customers who have not yet paid for goods or services rendered
The current liabilities category on a company’s balance sheet includes the following items:
- All debts and expenses a company is obligated to pay within the coming 12 months
- Short-term debts
- Interest and tax payments
- Accounts payable
- The cost of supplies and raw materials, rent, utilities, and other operational expenses
Understanding High Working Capital
If a company has very high net working capital, it generally has the financial resources to meet all of its short-term financial obligations. Broadly speaking, the higher a company’s working capital is, the more efficiently it functions. High working capital signals that a company is shrewdly managed and also suggests that it harbors the potential for strong growth.
Not all major companies exhibit high working capital. In fact, some large corporations have negative working capital, where their short-term debts outweigh their liquid assets. Typically, the only entities capable of remaining solvent amid these circumstances are behemoth corporations with significant brand recognition and robust selling power. Such companies are able to quickly generate additional funds, either by shuffling money from other operational silos, or by acquiring long-term debt. These companies can easily meet short-term expenses even if their assets are tied up in long-term investments, properties, or equipment rentals.
Though most businesses strive to maintain consistently positive working capital, in some cases, very high working capital may indicate that a company isn’t investing its excess cash optimally, or that it’s neglecting growth opportunities in favor of maximizing liquidity. In other words, a company that does not intelligently deploy its capital is potentially doing a disservice to itself and its shareholders. Extremely high net working capital may also mean the company is overly invested in inventory, or that it’s slow to collect on debts, which may indicate waning sales and/or operational inefficiencies.
Analyzing Working Capital
Because working capital figures can vary widely over time, and because they may differ from business to business, it’s important to analyze this metric within a broader, more holistic context. The industry, company size, developmental stage, and operational model of the given business must all be considered when assessing financial stability based on levels of net working capital.
In some industries, such as retail, high working capital is necessary to maintain smooth operations throughout the year. In others, businesses can run flawlessly on relatively low working capital, as long as they have consistently reliable revenues and expensesplus stable business models.
Both the current asset and current liability figures change daily because they are based on a rolling 12-month period. Consequently, the net working capital figure fluctuates over time. Changes in this metric from year to year are especially important because long-term shifting trends are more telling of a company’s financial prospects than any single figure examined in isolation.