How to evaluate the working capital of a company?

Guide To Fundamental Research | Published on 18th July 2018 | 556

When we talk of company evaluation, most of us tend to get caught up in the big picture. Capital structure, fixed assets investment, borrowings, net worth, ROE, ROCE; these are the issues we normally consider most relevant to valuation. But did you know that most of these big picture items cannot really be of any use if the working capital of the company is not managed properly. In fact, most companies run into problems when they fail to optimize their working capital. What working capital in the first place? Working capital is an indicator of whether the company is liquid enough to pay off its short term debts without impairing long term assets.

Understanding current assets and current liabilities…

The entire concept of working capital is based on the concept of current assets and current liabilities which refer to the short term assets and liabilities that you use to run your operations. Gross working capital of a company refers to the current assets while the net working capital of a company is the difference between current assets and current liabilities. How do we interpret net working capital? A positive working capital (where current assets are more than current liabilities) signals corporate health. But if the working capital is negative then it is a sign that your short term liabilities cannot be funded by your short term assets. That means you will have to fall back upon your long term assets to fund your short term payables. That is not a very healthy scenario to be in. Current assets include cash, marketable securities held for short term, accounts receivables (debtors) and inventories. Current liabilities include short term loans taken, accounts payable (creditors), taxes outstanding etc.

Working capital is a critical success area

Working capital goes beyond the long term capital and focuses more on the short term. It has been observed in the past that many companies have gotten into financial trouble purely due to poor working capital management. The company may have a strong long term balance sheet and may have raised long term funds at low cost, but the working capital must be a surplus as that is what impacts the operational efficiency of the company. One of the popular measures of net working capital is the change in working capital. But this can be easily manipulated and hence you must be cautious about this measure. One can increase the current assets by giving more liberal credit terms and increasing debtors. This will increase net working capital but will actually make your operational cycle more illiquid as more of your funds will now be stuck up in accounts receivable. At the end of the day, your business will still be crunched for cash. So the quality of working capital changes also matter.

Going one step beyond to the quick ratio

An interesting and practically better way of assessing working capital is to also look at the quick ratio. The current ratio is calculated as (Current Assets / Current Liabilities). A current ratio of greater than 2 is considered to be healthy. But current ratio has a limitation in that it does not differentiate between liquid current assets and illiquid current assets. For example, cash is liquid, marketable securities are liquid, debtor collections can be hastened but more often than not, inventories are unique to the business and hence they tend to be illiquid. That is where quick ratio comes in handy. The quick ratio excludes inventories from current assets as they are not easily convertible into cash. The quick ratio gives a more reliable picture of liquidity. But you need to take the extremes of current ratio and quick ratio with a pinch of salt. Just as a low current ratio is not good, a very high current ratio is also not desirable. It implies that the company is making inefficient use of its short term resources by locking it up in debtors and inventories. Effectively, the company is ending up financing its clients whereas it should be financing its vendors and suppliers.

When does negative working capital become acceptable?

Have you heard of the Japanese style of inventory management which is called JIT? Just in time (JIT) inventory management is all about fine tuning your logistics to such an extent that you do not need to worry about maintaining huge inventories. In such cases, negative working capital is understandable. Fast foods chains are a business where the inventory moves very fast and the credit period offered is almost zero. There is one more scenario where a negative working capital is acceptable. If current assets can be financed easily through assured credit lines and at a very competitive cost of funding, then the actual working capital ratios may not be too relevant. That is, of course, assuming that these low rates and competitive funding terms will sustain in the future too.

Measuring working capital turnover

An additional ratio to review is the working capital turnover ratio (WCTR). It measures the ratio of the net sales to the working capital of the company and measures how efficiently the working capital is being cycled to generate sales. It is one of the many efficient ratios used to evaluate a company. WCTR = (Net Sales / net working capital). Normally, higher the WCTR it is considered to be a sign of operating efficiency.

The importance of working capital in the long term profitability cannot be undermined. That is why some of the best manufacturing companies around the world spend substantial time and energy as well as top management bandwidth on getting a hang of working capital management. That is where companies’ performance really gets determined.