Working Capital and Working Capital Calculations
Working capital is an important measure of a company’s operating liquidity. The working capital ratio (a.k.a current ratio) is an indicator of the ability of the company to meet its short term obligations.
Calculations such as Net Current Asset Value (NCAV) and Net Net Working Capital (NNWC) provide valuable metrics with which to measure against price in order to identify bargain stocks.
Purpose of Working Capital
The purpose of working capital is to provide the liquidity required to efficiently run the operations of the business. The worst case scenario is when a company does not have the liquidity to pay its obligations and would have to file for bankruptcy.
Late payments can damage the reputation of a company. This may cause creditors to inflict penalties or refuse to deliver goods or services without upfront payment. A company struggling to pay its current bills is not going to have the capital to expand operations and grow earnings.
Working Capital Calculation
Working Capital = Current Assets – Current Liabilities
Current assets and current liabilities can be found in the balance sheet of the company financial statements. By subtracting the current liabilities from the current assets you have the net working capital which the company can use to operate the business.
Current assets include cash, investment securities, prepaid expenses, accounts receivable, and inventory. Current Liabilities consist of any obligations due within one year. This would include accounts payable, notes payable, dividends, taxes, wages, and the current portion of long-term debt.
Why Working Capital Calculations are Important
The purpose of the working capital calculation is to measure liquidity and efficiency of an enterprise. This provides insight into how proficient the company is at managing inventory, debt, accounts receivable, and accounts payable. While a lack of working capital can be devastating, too much could be a sign of mismanagement.
Working Capital Ratio Calculation
Working Capital Ratio or Current Ratio = Current Asset / Current Liabilities
By dividing the the current liabilities into the current assets you have a ratio called the working capital ratio or current ratio. A ratio below 1 would indicate the company has negative working capital and therefore does not have enough current assets to meet its short term obligations.
Benjamin Graham recommended a current ratio of at least 2 -1. Many lenders will require a 2-1 ratio in order to make a loan. This would mean the company has more than sufficient current assets to meet its obligations for the next year. An extremely high ratio is not necessarily a good sign. Too much working capital could be an indication that the capital is inefficiently allocated.
A secondary test of liquidity is know as the “acid test”. This is an important measurement because it determines whether a company would meet its obligations without selling inventory.
Acid Test Ratio = (Current Assets – Inventory) / Current Liabilities
Graham recommended that companies have a ratio of at least 1-1. That would indicate a company would meet its short term obligations without having to sell inventory.
Net Current Asset Value (NCAV)
One of Benjamin Grahams favorite types of bargains was finding Net Net Stocks. These are stocks whose market capitalization (price of the company equity) is less than the company’s net working capital. Graham did not stop at subtracting current liabilities from current assets, he subtracted total liabilities.
Net Current Asset Value (NCAV) = Current Assets – Total Liabilities (including preferred stock and long term debt)
This means that the price of the company stock is so low the investor is getting the fixed assets (building, equipment, machinery, etc) for free. Graham advocated buying a diversified group of stocks selling below their Net Current Asset Value.
Net Net Working Capital (NNWC)
An even more conservative calculation is net net working capital.
Net Net Working Capital = Cash + Short-term Marketable Securities + (0.75 x Accounts Receivable) + (0.5 x Inventory) – Total Liabilities
Net Net Working Capital allows for the potential that some accounts receivable may not be collectible and inventories may need to be discounted below their stated values on the balance sheet.
A stock whose market capitalization (price of the company) is less than net net working capital would certainly be a candidate for further research as a possible bargain buy.
Working capital calculations are valuable for analyzing liquidity, safety, and formulating important metrics that can be compared with price.
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While Arbor Investment Planner has used reasonable efforts to obtain information from reliable sources, we make no representations or warranties as to the accuracy, reliability, or completeness of third-party information presented herein. The sole purpose of this analysis is information. Nothing presented herein is, or is intended to constitute investment advice. Consult your financial advisor before making investment decisions.