3.30: Working capital
Working capital is distinguished from other forms of capital primarily because working capital is short term. In most cases it can be liquidated quickly; the usual distinction between short-term and long-term capital is that short-term capital turns over at least once per year. Working capital normally excludes shareholder accounts.
Working capital is the short-term capital used in the day to day operations of a business.
The common components of working capital are:
Current assets, typically:
- Cash
- Accounts receivable
- Inventory
- Prepaid expenses
Net of current liabilities, typically:
- Bank overdrafts or utilized banking facilities due within twelve months
- Accounts payable and accrued liabilities
- Taxes payable
- Portion of long-term debt due within twelve months
Over the years business analysts have figured out “normal” levels of working capital. This is sometimes expressed as a multiple of annual sales. Working capital can also be analysed on a more detailed basis, for example, current assets compared to current liabilities, “quick” assets (i.e. current assets less inventory) compared to current liabilities, inventory turnover, receivables and payables settlement periods, and so forth.
By comparing desirable levels of working capital to actual levels, some conclusions can be reached in respect to “redundant” (i.e. excess) working capital and the operational strengths and weaknesses of the business. See Redundant assets for a discussion on the valuation implications of redundant working capital.
Contact MVI for a more complete discussion of the implications of too much, or too little, working capital.