More of this Feature • Part 1: Lesson 3 Main • Part 2: How to Get Statements • Part 3: What's a Balance Sheet • Part 4: Typical Balance Sheet • Part 5: Current Assets • Part 6: Receivables • Part 7: Receivable Turns • Part 8: Inventory • Part 9: Inventory Turns • Part 10: Inventory Example • Part 11: Prepaid Expenses • Part 12: Current Liabilities • Part 13: Working Capital • Part 14: WC Per Dollar of Sales • Part 15: Negative Work. Cap • Part 16: Current Ratio • Part 17: Quick Ratio • Part 18: Long Term Investment • Part 19: Property, Plant, Equip. • Part 20: Intangible Assets • Part 21: Goodwill • Part 22: Deferred Charges • Part 23: Debt, Debt to Equity • Part 24: Other Liabilities • Part 25: Minority Interest • Part 26: Shareholder Equity • Part 27: Book Value • Part 28: Com. & Pref. Shares • Part 29: Cap. Surplus, Reserve • Part 30: Treasury Stock • Part 31: Retained Earnings • Part 32: Formula & Calculations • Part 33: Putting it all Together • Part 34: Segment 2

Related Resources • Investing Lesson 1 • Investing Lesson 2 • Investing Lesson 3 • More Investing Lessons

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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.

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