© 2000 John Petroff
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© 2000 John Petroff |
The combined resources making up current assets are the working capital of the company. It is appropriate to look at the overall size of this working capital in order to verify that sufficient resources have been devoted for that purpose. One could imagine, indeed, a firm that has an outstanding current ratio, but is practically inoperative with no trade liabilities and practically no inventory to sell.
1)- Total working capital
As stated above, total working
capital is measure by
Total Working Capital = Cash + Marketable Securities + Accounts
Receivable
+ Inventory + Prepaid expenses
The components of working capital usually comprise all the
components of Current Assets. However, that is not always so. Some modifications to working capital
may involve the exclusion of some components of current assets
such as
- compensating balance from cash (because it is a balance that
the bank requires to be left in the checking account, and it is
not therefore available to make payments),
- funds committed for expansion and temporarily placed in marketable
securities,
- non-current portion of inventory (e.g. unsalable goods, or inventory
in excess of current year needs),
- prepaid expenses and accrued revenues.
In addition, other modifications that may be necessary will be
mentioned when looking at individual components in the following
sections.
| As an example of calculation, Timken Balance Sheets show that for 1999 and 1998, total working capital was $ 833.5 millions and $ 850.3 millions respectively. This represented 34% of total assets in 1999 and 35% in 1998, as shown in Timken Normalized Balance Sheets. |
It can be observed in Table T-8.1 that the wholesale industry has the largest relative size of working capital with 80% of the assets, whereas telephone companies have about half of that with 41%. One can speculate that telephone companies may even have less real working capital than the 41% because the large holding of cash and equivalent of 13% (twice as much as the wholesale companies) is likely to be held as a requirement for compensating balance, expansion or safety. Remember that holding cash is expensive to a firm; it does so only if it is strategically necessary. Pharmaceutical companies also hold much cash because their large volume of research and development which is naturally risky. The comment is even more appropriate for travel agencies with an impressive 18% of total assets held as cash or equivalent. But the reason for the risk is different: it comes from the potential for cancellations (and consequently, refunds), and from the sizable current liabilities. The latter is best captured with the study of net working capital, and more will be said about cash balances later.
See review questions Q-8C.1 through Q-8C1.4.
2)- Net working capital
The net working capital NWC is
NWC = Working Capital - Current Liabilities
where Current Liabilities = Accounts payable + Notes payable
+ Short term bank credit
+ Current portion of long term debt
+ Accrued expenses and prepaid revenue.
In addition to the modifications
involving working capital, modifications of current liabilities
may be required because of
- refinancing arrangements of the firm (which would allow the
analyst to consider the bank short term debt as long term and
take it out of current liabilities), and
- off balance sheet liabilities such as warranties, sale with
right to return and factoring with recourse (all of these should
be added to current liabilities for a statistically determinable
portion resulting in likely obligations),
- exclusion of prepaid revenues, in totality of in part, because
they do not represent an actual liability but only a potential
liability in case customers decide to renege on their purchase.
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From Timken Balance Sheets one can observe that current assets were $ 833.5 millions, and current liabilities were $ 557.6 millions in 1999. Net working capital for Timken in 1999 is therefore NWC = 833.5 - 557.6 = 275.9 |
From Table T-8.1 it can be observed that the net working capital of travel agencies is slightly negative. However, because of the presence of other current liabilities of 26%, some of the current liabilities represent advances from customers which are not likely to be paid back, and therefore, the situation may not be as dramatic as it appears. The industry with the best net working capital is the pharmaceutical sector with 36%. Its healthy working capital position is attributable to the large equity placed in these companies: 58% of total assets. As stated earlier, liquidity can be the result of liquid assets holding or equity injection. Here, the equity is necessary because, once again, medical research is risky and must be financed by trusted owner's funds (i.e. not by lenders who can become scared of research failures).
See review questions Q-8C2.1 through Q-8C2.4.
See research assignments R-8C.1 and R-8C.2.
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