Working Capital Analysis of Companies
Working Capital and formula
Working capital is a measure of a company’s ability in the short run to pay its obligations. It looks at short-term financial health. Working capital is calculated as follows:
Working Capital = Current Assets - Current Liabilities
Current assets are defined as cash or other liquid investments, such as inventory and accounts receivable, that can be converted to cash within a year. Current liabilities are obligations that will be paid within a year, such as accounts payable and notes and interest payable. A positive value of working capital structure indicates that there are enough current assets to cover current obligations. Current measures of working capital can be compared to previous measures to determine if there has been a change that should cause concern.
To examine working capital, we will compare two companies: AEW, Inc., has $ 1,000,000 in current assets and $500,000 in current liabilities. AEW’s working capital is $500,000 ($ 1,000,000 current assets — $500,000 current liabilities).
UKF, Inc., has $20,000,000 in current assets and $19,500,000 in current liabilities. KF’s working capital is also $500,000 ($20,000,000 current assets — $19,500,000 current liabilities).
Obviously, there is a difference between working capital of$500,000 for AEW, Inc., with $ 1 ,000,000 in current assets, and KF, Inc., with $20,000,000 in current assets. In order to understand what working capitalof$500,000 means for a company’s liquidity, the analyst should study the following ratios to examine relationships between current assets and current liabilities: current ratio, quick (acid test) ratio, and cash ratio..
The current ratio measures the degree to which current assets cover current liabilities. A higher ratio indicates greater ability to pay current liabilities with current assets, thus greater liquidity. Current Ratio = ‘Current Assets /Current Liabilities Using the numbers from the example:
AEW has a current ratio of 2 ($1,000,000 + $500,000). AEW has sufficient current assets to pay its current liabilities twice. KF’s current ratio is 1.026 ($20,000,000 + $19,500,000); KF has sufficient current assets to pay current liabilities only once.
AEW and KF have the same working capital, but AEW is better positioned against uncertainty Wit is not able to obtain additional assets (via sales) in the near-term future. KF must generate additional current assets before the next cycle of debt obligations is due. It appears that AEW is more liquid than KF.
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