Working capital indicates how well the company is able to maintain its liquidity position in day-to-day operations.
Working Capital = Current Asset – Current Liabilities
Current asset indicates the assets which can be converted into liquid cash within the next 12 months. Current assets include – cash and cash equivalents, Account receivables, inventory, short-term investment, marketable securities, etc. Note that – all the current assets can be easily converted into cash in the next 12 months. For example – inventories can be sold and converted into liquid cash.
Current Liabilities indicate the obligations of the business which are due in the next 12 months.
Current Liabilities include – short-term debt, account payable, dividend payable, tax payable. Note that – all the current liabilities should be paid within the next 12 months. For example – short-term debt should be paid in the next 12 months.
If the lender who gave the money to the company for short-term debt comes and asks backs his money. The company should be able to pay back the money completely without any delay. If not so, we can conclude that there is liquidity constraint in the company.
Let’s assume the company has the current asset of Rs 20 Cr (cash Rs 10 Cr and inventory Rs 5 Cr and Short term investment Rs 5 Cr). The current liability is Rs 10 Cr (short-term debt is Rs 10 Cr). Now the working capital is Rs 10 Cr (20-10). This positive Rs 10 Cr indicates that the company has got sufficient current assets to take care of short-term obligations. In our case, if the lender suddenly one day asks for his money back immediately, the company will be in a comfortable position because, in the current asset, they have cash of Rs 10 to pay back to the lender immediately.
So working capital tells how well the liquidity position is managed by the management in day-to-day operations.
How to use it practically
The main components of working capital are inventory, trade payables, and trade receivables. If the company has positive working capital it is a good sign that the company has got sufficient assets to pay off the future obligation.
But if you see that working capital is increasing for the company but the sales are declining then it is not a good sign and we need to analyze the individual component of working capital to come to any meaningful conclusion.
Look for companies where the sales are going and the working capital position is kept in check by the management. For example, if the sales are growing but inventories are growing faster than sales, then it indicates that the company is not able to convert its inventory into sales. Likewise, while analyzing working capital, each and every component should be analyzed individually to make good investment decisions.