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Working Capital
The
number one reason most people look at a balance sheet is to find out a company's
working capital (or "current") position. It reveals more about the
financial condition of a business than almost any other calculation. It
tells you what would be left if a company raised all of its short term
resources, and used them to pay off its short term liabilities. The more
working capital, the less financial strain a company experiences. By
studying a company's position, you can clearly see if it has the resources
necessary to expand internally or if it will have to turn to a bank and take on
debt.
Working
Capital is the easiest of all the balance sheet calculations. Here's the
formula:
Current Assets - Current
Liabilities = Working Capital
One of
the main advantages of looking at the working capital position is being able to
foresee any financial difficulties that may arise. Even a business that
has billions of dollars in fixed assets will quickly find itself in bankruptcy
court if it can't pay its monthly bills. Under the best circumstances,
poor working capital leads to financial pressure on a company, increased
borrowing, and late payments to creditor - all of which result in a lower credit
rating. A lower credit rating means banks charge a higher interest rate,
which can cost a corporation a lot of money over time.
Companies
that have high inventory turns and do business on a cash basis (such as a
grocery store) need very little working capital. These types of businesses
raise money every time they open their doors, then turn around and plow that
money back into inventory to increase sales. Since cash is generated so
quickly, managements can simply stock pile the proceeds from their daily sales
for a short period of time if a financial crisis arises. Since cash can be
raised so quickly, there is no need to have a large amount of working capital
available.
A company
that makes heavy machinery is a completely different story. Because these
types of businesses
are selling expensive items on a long-term payment basis, they can't raise cash
as quickly. Since the inventory on their balance sheet is normally ordered
months in advance, it can rarely be sold fast enough to raise money for
short-term financial crises (by the time it is sold, it may be too late).
It's easy to see why companies such as this must keep enough working
capital on hand to get through any unforeseen difficulties.
Next page > How to know how
much Working Capital a company needs> <<
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