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Working Capital

Investing Lesson 3 - Analyzing a Balance Sheet


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One of the main reasons serious investors look at a balance sheet is to find out a company's working capital (or "current") position. Working capital reveals more about the financial condition of a business than almost any other calculation because it tells you what would be left if a company took all of its short-term resources, and used them to pay off its short-term liabilities. The more working capital a firm has on hand, 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.


Calculating Working Capital

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.


Negative Working Capital Can Be a Good Thing for High Turn Businesses

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 stockpile 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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This page is part of Investing Lesson 3 - Understanding the Balance Sheet. To go back to the beginning, see the Table of Contents. If you have already read this lesson, you can skip directly to the Balance Sheet Quiz.

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