The Working Capital Ratio in Stock Analysis
The working capital ratio is a measure of a company’s efficiency and its near-term financial health. A company’s working capital can be positive or negative (depending on how much debt the company is carrying) and measures how much the company has available in liquid assets to build the business. The management of working capital includes inventories, accounts receivable and accounts payable and managing cash. It quite simply dictates a company’s capacity to do business.
Calculating the Working Capital Ratio
The working capital ratio is calculated by subtracting current assets from current liabilities and it can give investors a good indication of the company’s operating efficiency. It indicates what would be left if a company paid off its short term liabilities with its short-term resources. Generally speaking, the more working capital a company has the less financial strain it will experience.
The Value of Working Capital
Companies require positive working capital to ensure that they are able to continue operations and fund short-term debt and operational expenses. Companies with adequate working capital are often in a good position to be successful as they are able to fund expansion. Companies with negative working capital may not have this opportunity. All else being equal, a company that has positive working capital will outperform a company that does not.
Working capital does not include money that is tied up in inventory or money that customers still owe to the company. A company must, therefore, operate in an efficient manner (collect on obligations) or its working capital will be negatively impacted. Fundamental investors will often compare the measure from period to period to see how operating efficiencies have improved or declined.
Operational Efficiency
Working capital demonstrates the operational relationships between the company, its customers and its suppliers. It is an important measure for an investor to observe as the detection of trading challenges within these relationships can signal a significant red flag.
It should be noted that requirements differ among industries. Companies that have quick inventory turnovers and generate cash quickly don’t usually need as much working capital as companies that have slower inventory turnover.
Another good article on the working capital ratio
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The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.
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