Working capital

Working capital is the difference between current assets and current liabilities and simply calculated by

Working capital  = current assets  - current liabilities

Following a simple break down of what current assets and liabilities might be.

Analysis of working capital is especially important for the firms that work on inventories rather than fixed assets or people resources. Most common example is the retailers that hold huge amount of inventories. Inventory forms major part of their assets and seeing their value is important to asses their current financial status in the market.

There are mainly two important implications of working capital:

1. If a company's current assets do not exceed its current liabilities, then it may run into trouble paying back creditors in the short term. The worst-case scenario is bankruptcy. A decline in working capital ratio in the long term could be a red flag that requires further analysis. For example, it could be that the company's sales volumes are falling.
2. Working capital also gives investors an idea of the company's underlying operational efficiency. Money that is tied up in inventory or money that customers still owe to the company cannot be used to pay off any of the company's obligations. So, if a company is not operating in the most efficient manner, it will show up as an increase in the working capital. The working capital values can be compared with older terms to see if there is any slowness in the collection of money. That slowness might be an another indication of problem in the company's operations.

The widely observed indicator to see whether working capital is used efficiently is Cash Conversion Cycle.

Cash Conversion Cycle

The cash conversion cycle is the number of days between paying for inventories and receiving cash from selling these inventories or any goods made from that inventories. The cash conversion cycle is a measure of working capital efficiency, often giving valuable clues about the underlying health of a business. The higher the number, the longer a firm's money is tied up in business operations and unavailable for other activities such as investing.

Since a company uses its cash to buy inventory but does not collect cash until the inventory is sold, the days inventory outstanding (DIO) (the number of days that inventories are kept unsold) and the days sales outstanding (DSO) (the number of days that goods stay for sale) are summed up. However, days payable outstanding (DPO) which essentially represent loans from vendors to the company is subtracted as relief for working capital needs. The cash conversion cycle is given by the following formula:

CCC = DSO+DIO-DPO

• DIO: days inventory outstanding.
• DSO: days sales outstanding.
• DPO: days payable outstanding.

References:

1.  http://www.schaeffersresearch.com/schaeffersu/advanced/financialstatements/financialstatements6.aspx

2. http://en.wikipedia.org/wiki/Cash_conversion_cycle

3. http://www.investopedia.com/terms/w/workingcapital.asp