Financial Statement Analysis
- Ratio Analysis of Financial Statements (Formula, Types, Excel)
- Ratio Analysis
- Liquidity Ratios
- Turnover Ratios
- Profitability Ratios
- Profit Margin
- Gross Profit Margin Formula
- Operating Profit Margin Formula
- Net Profit Margin Formula
- EBIDTA Margin
- Earnings Per Share
- Basic EPS
- Diluted EPS
- Basic EPS vs Diluted EPS
- Return on Equity (ROE)
- Return on Capital Employed (ROCE)
- Return on Invested Capital (ROIC)
- Return on Total Assets (ROA)
- Return on Average Capital Employed
- Capital employed Employed
- Return on Average Assets (ROAA)
- Return on Average Equity (ROAE)
- Return on Assets Formula
- Return on Equity Formula
- DuPont Formula
- Net Interest Margin Formula
- Earnings Per Share Formula
- Diluted EPS Formula
- Contribution Margin Formula
- Revenue Per Employee Ratio
- Operating Leverage
- EBIT vs EBITDA
- Capital Gains Yield
- Tax Equivalent Yield
- LTM Revenue
- Operating Expense Ratio Formula
- Overhead Ratio Formula
- Capacity Utilization Rate Formula
- Total Expense Ratio Formula
- Efficiency Ratios
- Dividend Ratios
- Debt Ratios
- Debt to Equity Ratio
- Debt Coverage Ratio
- Debt Ratio
- Debt to Income Ratio Formula (DTI)
- Capital Gearing Ratio
- Capitalization Ratio
- Interest Coverage Ratio
- Times Interest Earned Ratio
- Debt Service Coverage Ratio (DSCR)
- Financial Leverage Ratio
- Net Debt Formula
- Leverage Ratios
- Operating Leverage vs Financial Leverage
- Current Yield
- Debt Yield Ratio
Working Capital Ratio|Formula | Management | Financing – Sears Holding stock fell by 9.8% on the back of continuing losses and poor quarterly results. Sears balance doesn’t look too good either. Moneymorning has named Sears Holding as one of the five companies that may go bankrupt soon.
Especially, if you check the working capital situation of Sears Holdings and calculate the working capital ratio, you will note that this ratio has been decreasing continuously for the past 10 years or so. Working Capital ratio below 1.0x is definitely not good.
Working Capital is very important for the business to run its operations smoothly and meet their day to day fund requirements. In this article, we look at Working Capital in detail –
- What is working capital?
- How to measure working capital?
- Working Capital Ratio Formula
- Changes in working capital ratio
- Working Capital vs Liquidity
- Negative working capital
- Negative working Capital Example
- Managing working capital
- Working capital financing
What is working capital?
Working capital is the day-to-day fund requirements for an organization’s trading operations. It measures a company’s financial health. This is because if a company cannot manage to pay for its day to day activities, it might not be able to see a long term future.
It is also at times known as revolving capital / circulating capital / short-term capital as it caters to the short-term financing needs of a business.
How to measure working capital?
Working Capital = Current Assets – Current Liabilities
Working Capital Ratio = Current Assets ÷ Current Liabilities
Generally speaking, working capital ratio is analyzed as follows:
- If this ratio around 1.2 to 1.8 – This is generally said to be a balanced working capital ratio and it is assumed that the company is a healthy state to pay its liabilities.
- If it is less than 1 – It is known as negative working capital which generally means that the company is unable to pay its liabilities. A consistently negative working capital may also lead to bankruptcy. (Detailed explanation given in a later segment)
- If this ratio is greater than 2 – Company may have excess and idle funds which are not utilised well. This should not be the case as the opportunity cost of idle funds is also high.
However, these ratios generally differ with the industry type and will not always make sense.
Working Capital Ratio Formula
Before, we look at the formula, let us look at the key components of working capital – Current Assets and Current Liabilities.
In general words, current assets include cash and other assets which can be converted to cash within a year’s span.
source: Colgate 2015 10K
- Short term investment in mutual funds
- Accounts receivable
- Inventory (Consists of raw materials, work-in-progress and finished goods)
- Bank balance
Current liabilities are such which will be due within a year or will have to be paid within a span of one year.
source: Colgate 2015 10K
Examples of current liabilities are:
- Accounts payable
- Notes payable (due within a year)
- Other expenses which are generally payable in a month’s time such salary, material supply, etc.
Let us calculate from working Capital for Colgate from the images above.
- Current Assets (2015) = $970 + $1,427 + $1,180 + $807 = $4,384
Current Liabilities = Notes and loans payable + Current portion of long term debt + Accounts Payable + Accrued Income Taxes + Other Accruals
- Current Liabilities (2015) = $4 + $298 + $1,110 + $277 + $1,845 = $3,534
Working Capital (2015) = Current Assets (2015) – Current Liabilities (2015)
- Working Capital (2015) = $4,384 – $3,534 = $850
Working Capital Ratio Formula = Current Assets / Current Liabilities
- Working Capital Ratio (2015) = $4,384 / $3,534 = 1.24x
Working Capital Ratio is also known as Current Ratio
Changes in working capital ratio
As explained above, working capital is a dynamic figure and keeps changing with change in both assets / liabilities. The following table summarizes effects of changes in individual components of working capital:
|Components of Working Capital||Change||Effect on Working Capital|
Working Capital vs Liquidity
As discussed earlier, working capital is the difference between its current assets and liabilities. These are stand-alone financial figures which can be obtained from a company’s balance sheet. This is not a proof of a company’s liquidity position.
Let us understand this with the help of an example:
|Particulars||Company WC||Company Liquid|
|Working Capital Ratio||1:1||2:1|
In the above case, Company Liquid seems to be more liquid as compared to Company WC. Now, let us include some more details to the above table
|Particulars||Company WC||Company Liquid|
|Average collection period (A/cs Receivable)||30 days||120 days|
|Average payment period (A/cs Payable)||60 days||90 days|
Taking the above two stats, it is clear that Company WC will be able to generate cash in a more efficient way rather than Company Liquid. Working Capital Ratio alone is not sufficient to determine the liquidity. The following other financial indicators are also required:
- Days inventory outstanding formula = Cost of sales per day ÷ Average inventories
- Days sales outstanding formula = Net sales per day ÷ Average Accounts Receivable
- Days payable outstanding formula = Cost of sales per day ÷ Average Accounts Payable
These measure the respective turnovers e.g. days inventory outstanding means how many times the inventory was sold and replaced in a given year.
The three of the above indicators can be used to measure the Cash Conversion Cycle (CCC) which tells the number of days it takes to convert net current assets into cash. Longer the cycle, the longer the business has its funds utilized as working capital without earning a return to it. So the business should aim to minimize the CCC as far as possible.
Cash Conversion Cycle (CCC) = Days inventory outstanding + Days sales outstanding – Days payable outstanding
Cash Conversion Cycle (CCC) will be a better measure to determine the liquidity of the company rather than its working capital ratio.
Negative working capital
Negative working capital is when a company’s current liabilities exceed its current assets. In this case, the working capital ratio is less than 1. As mentioned earlier, it is generally perceived that negative working capital means that the company is unable to pay its current liabilities and hence it is a potential threat to the business. This is true but there are also sectors / businesses where negative working capital is beneficial.
Negative Working Capital Examples
XYZ Online is an online marketplace for buying and selling of clothes apparel. For the ease of understanding, let us say that it has only one listed seller – AB Corp and only one payment gateway – PayO.
Prepaid collections by PayO are remitted on T + 1 basis
Account settlement with AB Corp is done once in 10 days
Now, a customer books a prepaid order online worth Rs. 1000 on 01-Mar-2016. Transaction flow for this order will be as follows:
|01-Mar-2016||Order Received on the portal||1000||NA|
|02-Mar-2016||Money received from PayO post deduction of processing fees||999||Inflow|
|10-Mar-2016||Amount remitted to AB Corp post deduction of Commission||990||Outflow|
AB Corp has a net gain of Rs. 9 (10 minus 1) on this transaction without investing any working capital. In fact it has received Rs. 1000 in advance. And this is exactly why it has a negative working capital. Most of the time, it will have liabilities more than its assets.
Vodafone Negative Working Capital
Another example where negative working capital is beneficial is telecom. Even though it is a capital intensive sector, they generally incur heavy expenditure in the first couple of years itself. Post which only route expenses are incurred.
With respect to the collections, a huge proportion of its receivables is collected through prepaid customers which will be similar to the e-commerce industry explained above. The credit period for postpaid customers is not much either.
See below – Vodafone has Negative working Capital (Current Assets are less than Current Liabilities)
source : Vodafone
Managing working capital
Working capital management has an impact on the liquidity, profitability and financial health of the organization. If the following main components of Working Capital are managed, working capital as a whole can be managed:
A balanced inventory should be maintained to optimize working capital requirements. Inventory should not remain idle nor should the company lose out on sales / production because it does not have sufficient inventory in hand.
Production, sales and procurement budgets should go hand-in-hand and prepared well in advance. While preparing these budgets, working capital should play an important role.
What happens in actual scenario is that the sales budget is fixed first and it is taken as a base for production plan which in turn is used as the base for the procurement budget. It is obvious that every organization wants to focus on sales and achieve their sales targets. But it is also important to note that money is required to procure and produce and money from sales will be recovered after the goods are sold.
Accounts receivable management
As mentioned earlier, Accounts Receivable forms an important part of working capital for any given business. To have a control on working capital, it is highly important to properly manage Accounts receivable. The following steps should be taken:
- Streamline customer billing and payment process while dealing with individual customers. Every organization has set of requirements to be fulfilled before they release payments for their invoices. Make sure that these processes are met on a timely manner.
- Organise regular meetings with customer to ensure that both are on the same page
- Contractual arrangements should include upfront advance and other payment terms should be favorable as well
- Regular follow-up with the client should be done for long dues outstanding.
- Ageing schedules should be circulated to management so that appropriate and timely action can be taken by them
Accounts payable management
In everyday routine, we call these payments as vendor payments. Companies do not take vendor payments seriously as they hit their bank account. But these are equally important as they will stop supplying goods / services. Goodwill of the organization also gets spoilt in the market. This will affect the working capital in the long run as the organization will not get credit facility, discounts, negotiation power, etc.
Balance should be maintained between accounts receivable and payable to have optimum utilization of working capital.
Some of the controls which a company should have in place to have optimum working capital are:
- A daily limit should be set for payments to be processed and the same should be tracked through daily dashboards for cheques issued – cleared & pending
- Accounts receivable reconciliations and ageing statements should be shared with all respective stakeholders for timely action
- A tracker for payments to be received should also be maintained on the basis of tentative timelines received from clients
- Cash flow statement should be circulated within the finance team which will help them to have a clear picture about the working capital burn / loss in the current month.
Working capital financing
Working capital cannot always be generated from the company’s funds. Also, even if the company can generate funds, it may be beneficial to have working capital financing options available. Some of these options are as follows:
- Cash credit or overdraft facility with banks – Negative balance can be maintained with the bank up to a certain authorized limit as sanctioned by the bank. e.g. A bank sanctions an overdraft facility of $1.75 million against a Fixed Deposit of $2 million. In this case, the bank balance can be negative to an extent of $1.75 million and the bank will charge interest to the extent the amount is used. At the same time, you will earn interest on $2 million deposit.
- Traditional loans can be availed from various banking or non-banking financial institutions. An organization must check different options for the best interest rates.
- Credit card payments generally buy time of around 20 to 30 days and offer other benefits such as discounts and reward points for corporate users.
- Letter of credit – In case of a letter of credit, the bank will pay the opposite party as soon as the party performs the agreed terms and you will then have to pay the bank. By issuing letter of credit, you get an additional buffer of 15-20 days over and above the normal credit period as the bank makes payment on your behalf.
- Inter-corporate deposit is also a good option for working capital management especially in case of group companies. A holding company having excess funds may lend its subsidiary of company at a slightly lower rate of interest than the market but the group as a whole can benefit by saving on the transaction costs and interest lost on idle funds.
Apart from financial cost, flexibility and ease of financing should also be taken into accounting while selecting a working capital financing option. A mix of the two or three options can also be selected.