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Working capital is a financial measure of the resources a company has readily available to cover the costs of its day-to-day operations, such as staff salaries, rent, electricity and water.
The working capital formula
Working capital is calculated with the formula:
Working capital = Current assets – Current liabilities
You can easily calculate working capital from a company’s financial statements. For example, for Vingroup (VIC) in Q3/2021, we can easily see that current assets were VND 180,400 billion and current liabilities VND 148,238 billion, so VIC’s working capital was 180,400 – 148,238 = VND 32,162 billion.
The formula shows that after the company uses its current assets to pay off all of its current liabilities, what remains, called working capital, can be used to pay for any of the company’s activities.
What working capital tells you
As explained above, working capital measures the capital a company can use freely to fund its business operations. If a company has positive working capital, its asset structure is safe, since current assets exceed current liabilities, and its production and business activities can run normally. Conversely, negative working capital means the company’s current assets are not enough to cover its short-term obligations, indicating poor liquidity and pressure to generate cash flow to repay debts on time.
Maintaining enough working capital is very important. Every company goes through difficult periods when it cannot generate cash flow but still has to pay its costs, and working capital is the resource that helps it cover those costs.
A company’s assets, both non-current and current, are used to generate cash flow and profit and to increase value for shareholders (shareholders’ equity). All non-current assets, such as machinery, equipment and factories, can be put to work to create value for the business, but current assets cannot. Part of the current assets has to be used to repay current liabilities as they fall due, and the company can only put the surplus, i.e. working capital, to work creating value. Fixed assets and working capital can therefore be described as the two main resources a company uses to generate cash flow.
Financial ratios related to working capital
The current ratio
This is a familiar ratio that I introduced in the article on financial ratios, calculated by dividing current assets by current liabilities. Since the difference between the two is working capital, the ratio tells us whether the company has a lot or a little working capital, and therefore how safe its capital position is. That is why the current ratio is often also called the working capital ratio.
The higher the current ratio, the safer the company’s asset structure and the more working capital it has. In my view, however, the ratio is best in the 1.2–2.0 range, showing that the company has enough working capital to cover its costs without carrying too much. Holding too much working capital can slow a company’s growth, because the money is not being invested in fixed assets to expand production and business, which could generate more cash flow in the future.
In the VIC example above, the working capital ratio is 180,400/148,238 = 1.22, showing that the company has just enough working capital to run smoothly.
Working capital turnover
This ratio measures how efficiently a company uses its working capital to generate revenue. It is calculated by dividing net revenue by average working capital. The higher the ratio, the more efficiently the company uses its working capital.
Working capital turnover has a similar meaning to total asset turnover, but it cannot always be used, because some companies have negative working capital.
Non-cash working capital
A company can only use cash to pay costs or debts as they fall due, so assessing the quality of its working capital is extremely important. A company may have positive working capital, but if most of its current assets are receivables and inventory, that is not necessarily good. To get the truest picture of a company’s cash flow, analysts therefore also use non-cash working capital. Here, the working capital formula is adjusted by removing cash from current assets and excluding borrowings from current liabilities.
In other words, with non-cash working capital we pay particular attention to receivables and inventory among current assets, and to trade payables and customer advances among current liabilities. These are the main drivers of the company’s cash conversion cycle. Non-cash working capital is also called adjusted working capital, or operating working capital, because it only considers items related to the company’s operations.
From a company’s point of view, it will always want to use credit from suppliers or customers for as long as possible (buying on credit), and to keep receivables (e.g. sales on credit) and inventory to a minimum. Large companies with strong market positions can do this, but small companies with weaker positions and less reputation often have to sell on credit to customers, or pay deposits to suppliers, in order to sign contracts with large customers or suppliers, which increases their non-cash working capital. In addition, many retailers have to buy goods in large quantities before selling them to customers, which also increases inventory and non-cash working capital.
How does working capital affect cash flow?
When a company sells on credit, it can still recognise revenue and profit as normal, but instead of receiving cash it records a receivable in its financial statements. An increase in receivables therefore reduces the company’s cash flow.
Likewise, when a company spends money buying inventory, inventory rises and cash flow falls.
When a company buys on credit from a supplier, trade payables in current liabilities increase. If the company sells that item to a customer, the cost of goods sold is still recognised, but the company has not actually paid the supplier anything yet, which increases its cash flow.
From the points above, you can see that an increase in non-cash working capital reduces the company’s actual cash flow. In general terms, a company’s operating cash flow (CFO) can be calculated with the formula below:
CFO = Profit after tax + Depreciation – Gains on asset disposals – Change in non-cash working capital
As I have just explained, an increase in operating working capital reduces a company’s cash flow. However, to work with large customers and partners, a company has to accept higher operating working capital and lower cash flow. Current cash flow may fall, but with large contracts signed, future cash flow may be greater. That is why we can say the company is making a working capital investment.
Below, I calculate the working capital of VIC.
You can see that the company’s working capital barely changed in Q2 but rose sharply in Q3. This reduced the company’s cash flow in Q3, but we can hope that the company is investing in working capital to generate more revenue in the future.
Fixed assets and working capital are the 2 main resources a company uses to generate future cash flow. A company can invest in fixed assets (buying equipment and factories) to expand production, and also invest in working capital (buying inventory, extending receivables) to sell more in the future. However, investment in fixed assets and working capital has to prove its worth: the company’s revenue must grow. If working capital keeps rising without accompanying growth in revenue or cash flow, investors should be cautious about investing in such companies.
Happy trading!
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