What does high working capital say about a company's financial prospects?

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A:

If a company has high working capital, it has more than enough liquid funds to meet its short-term obligations. Working capital, also called net working capital, is a liquidity metric used in corporate finance to assess a business' operational efficiency. It is calculated by subtracting a company's current liabilities from its current assets.

Current assets are highly liquid assets, meaning they can be converted to cash within a year. Typically, the current asset entry on a company's balance sheet includes the value of any cash on hand; checking and savings accounts; and marketable securities such as stocks, bonds and mutual funds. It may also include a company's inventory, which is to be sold within the next year, and accounts receivables, which are debts owed by customers who have not yet paid for goods or services rendered.

The current liabilities figure includes all debts and expenses the company must pay within the coming 12 months. Short-term debts, interest and tax payments, accounts payable, the cost of supplies and raw materials, rent, utilities and other operational expenses are all current liabilities.

Interpretation of High Working Capital

If a company has very high net working capital, it has more than enough current assets to meet all of its short-term financial obligations. In general, the higher a company's working capital, the better. High working capital is considered a sign of a well-managed company with the potential for growth.

However, some very large companies actually have negative working capital. This means their short-term debts outweigh their liquid assets. Typically, this scenario only works for huge corporations with the brand recognition and selling power to stay afloat in most any circumstance. These mega-companies have the ability to generate additional funds very quickly, either by moving money around or through the acquisition of long-term debt. They can meet short-term expenses with ease even if their assets are tied up in long-term investments, property or equipment.

Though most businesses strive to maintain consistently positive working capital, an extremely high figure is not always necessary. In some cases, very high working capital may indicate the company is not investing its excess cash optimally, or it is neglecting growth opportunities in favor of maximum liquidity. Though a positive figure is generally preferable, a company that does not put its capital to good use is doing itself, and its shareholders, a disservice. Extremely high net working capital may also mean the company is overly invested in inventory or slow to collect on debts, which could be indicative of waning sales or operational inefficiencies.

Analyzing Working Capital

Because the working capital figure can vary so widely over time and from business to business, it is important to analyze this metric within a broader context. The industry, size, stage of development and operational model of the given business must all be considered when assessing financial stability based on net working capital.

In some industries, such as retail, high working capital is necessary to maintain smooth operations throughout the year. In others, businesses can run on relatively low working capital without incurring issues if they have consistent revenues and expenses, as well as a stable business model.

Both the current asset and current liability figures change daily because they are based on a rolling 12-month period. The net working capital figure, therefore, also changes over time. Changes in this metric from year to year are especially important because increasing or decreasing trends indicate more about a company's financial prospects than any one figure in isolation.


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