How to Calculate Working Capital on the Balance Sheet explained by professional Forex trading experts the “ForexSQ” FX trading team.
How to Calculate Working Capital on the Balance Sheet
One of the major reasons serious and professional investors want to analyze a company’s balance sheet is because doing so lets them discover an enterprise’s working capital, or “current position”. Working capital reveals more about the financial condition, or at the very least, the short-term liquidity position, of a business than almost any other financial ratio or balance sheet calculation because it tells you what would remain if a company took all of its short-term resources and used them to pay off its short-term liabilities.
All else equal, the more working capital a firm has on hand, the less financial strain a company experiences. On the other hand, if a company keeps too much working capital, it can drag down returns and investor might have been better off if the board of directors decided, instead, to distribute some of that surplus in the form of dividendsor share repurchases.
By studying a company’s current position or working capital levels, you can see if it has the resources necessary to expand internally or if it will need to turn to a bank or financial markets to raise additional funds.
How to Calculate Working Capital From a Balance Sheet
Working capital is the easiest of all the balance sheet calculations to learn to calculate. Here’s the formula you’ll need:
Current Assets - Current Liabilities = Working Capital
One of the main advantages of looking at the working capital position is being able to foresee many potential financial difficulties that may arise.
Even a business that has billions of dollars in fixed assets will quickly find itself in bankruptcy court if it can’t pay its bills when they come due. Under the best circumstances, insufficient levels of working capital can lead to financial pressure on a company, increased borrowing, and late payments to creditors and vendors – all of which result in a lower corporate credit rating.
A lower credit rating means banks and the bond market demand higher interest rates, which can cost a corporation a lot of money over time as the cost of capital rises and less revenue makes it to the bottom line.
Negative Working Capital on the Balance Sheet Can Be a Good Thing for High-Turn Businesses
Companies that enjoy high inventory turns and do business on a cash basis (such as a grocery store or discount retailer) need very little working capital. These types of businesses raise money every time they open their doors, then turn around and plow that money back into inventory to increase sales. Since cash is generated so quickly (often from a source known as vendor financing), management can simply stockpile the proceeds from their daily sales for a short period of time if a financial crisis arises. This makes it unnecessary to keep large amounts of net working capital on hand.
In contrast, a capital-intensive firm, such as a company responsible for manufacturing heavy machinery, is a completely different story. Because these types of businesses are selling expensive items on a long-term payment basis, they can’t raise cash as quickly. Since the inventory on their balance sheet is normally ordered months in advance, it can rarely be sold fast enough to raise capital for short-term financial crises (by the time it is sold, it may be too late).
It’s easy to see why companies such as this must keep enough working capital on hand to get through any unforeseen difficulties.
How to Calculate Working Capital on the Balance Sheet Conclusion
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