Working Capital = Current Assets - Current Liabilities
It is important for a company to have a positive working capital position so that it's current assets can meet it's current liabilities (over a one year short-term period). If the current assets of a company is not able to meet it's current liabilities, a company will have to raise cash (by employing debts or other forms of capital raising) to meet it's current liabilities failing which in most drastic case may mean bankruptcy for the company.
Types of current assets and their amounts held by a company can influence it's liquidity and short-term financial health
There are various items that are considered as current assets that can be converted to cash in a one year short-term period (e.g. cash and cash equivalents, equities held for trading or sometimes called marketable securities or short-term investments, accounts receivables and inventory). The breakdown of all these current assets held by a company can be found under it's balance sheet statement.
It is important to understand how each of these types of current assets can affect the company's short-term financial health. Cash and cash equivalents are the most liquid of all the types of current assets that can be converted readily into cash to pay off current liabilities. Next in order are equities held for trading or any equivalent short-term investments that can be readily converted into cash. Accounts receivables are also fairly liquid depending on the estimated number of days a company needs to wait to receive payments for their goods sold or service rendered. Inventory is the least liquid assets held by a company because the company has to go through the entire process of selling and waiting for payments on the goods sold.
Thus, it is important to evaluate carefully the proportion of each type of current assets held by a company to determine it's short-term liquidity and financial health. A company may have a much higher total current assets than it's total current liabilities. However, if a substantial proportion of the current assets consists of inventory, it maybe quite worrying should a company not be able to sell it's goods under the inventory held. If a company has a trend over the years of high amount of assets held in it's inventory, this maybe a red flag for greater financial problems to come especially if the company also has a poor "cash conversion cycle" (high number of days required for the entire cash conversion cycle). All these may suggest difficulty in selling the company products and the company also has difficulty in collecting payments from products sold if the cash conversion cycle is poor. A high amount of current assets held in inventory may not always necessarily be a bad sign provided the company has an excellent cash conversion cycle.
Based on the order of liquidity of the various types of current assets, it may suggest that a higher amount of current assets held in cash and cash equivalents is best since it can be most readily converted into cash to meet the current liabilities. This is true only to a certain extent. If the company has a trend of having too much assets held in cash and cash equivalents, it may also suggest that the company is unable to deploy it's cash to productive use to grow it's business and make meaningful returns.
Thus, when evaluating any types of current assets, similar to evaluating any single metric of measurement, one has to be careful not to make any sweeping mistakes in judgment by not considering other metrics of measurements together in order to see the big overall picture of a company's investment worthiness. A trend of high amount of current assets held in inventory with a trend of increasing revenue, increasing net income, increasing gross and net margins and increasing positive cashflows may instead paint a good picture instead of a grim outlook based on making a biased judgment on looking at a trend of high amount of assets held in inventory alone.
Financial ratios to evaluate a company's liquidity and short-term financial health
When evaluating liquidity of a company, there are various financial ratios one can consider such as current ratio, quick ratio and cash conversion cycle. I have already discussed cash conversion cycle in my earlier post. I shall discuss current ratio and quick ratio, and then provide a comparison between these different types of financial ratios. All the figures used in the calculations of the financial ratios discussed below can be found under the current assets and current liabilities of the balance sheet statement.
Current ratio
Current ratio is the simplest financial ratio to determine the liquidity of a company. It is also the most commonly used and stated financial ratio by analysts and investment firms. The current ratio only measures the short-term financial health of a company by considering whether its current assets is able to meet its current liabilities. Thus, a current ratio of more than 1 is preferred so that a company's current assets can meet its current liabilities fully. The shortfall with using this financial ratio is that it does not consider the types of current assets and their amount held as mentioned above. By using this financial ratio, one is assuming that all current assets can be readily converted into cash to meet the current liabilities which often is not the case (e.g. inventory that cannot be sold quickly or accounts receivables that cannot be realised quickly).
Quick ratio
Another financial ratio that considers only the more liquid assets that can be converted into cash to meet the current liabilities is the quick ratio. As seen in the formula above, inventory is not considered in the caculation since it is not easily converted into cash (offers least liquidity). As such, quick ratio is a more conservative financial ratio than current ratio when assessing the short-term liquidity and financial health of a company. A quick ratio of more than 1 is preferred so as to allow the more liquid assets to meet the current liabilities fully.
Cash conversion cycle
Cash conversion cycle is another way to measure a company's liquidity based on considering the days in inventory, days in receivables and days payable outstanding (see my previous post on cash conversion cycle http://jeremyowinvestingexperience.blogspot.com/2009/11/cash-conversion-cycle-important.html). Cash conversion cycle is a better measurement of the liquidity and short-term financial health of a company by considering how fast the company sells it's goods held in inventory, how fast it receives payments for goods sold or services rendered and how long it can be able to delay it's payments to suppliers of goods. A company that can sell goods fast, receives payments fast and have sufficient time to pay it's suppliers has a shorter cash conversion cycle (in terms of shorter number of days) and thus a better liquidity and working capital position (ability to raise cash fast from it's operations) to meet it's currrent liabilities.
Thus, cash conversion cycle maybe a better and more critical way to measure a company's liquidity. Most often, it is a poor cash conversion cycle that drags down a company's liquidity and short-term financial health more so than the amounts and types of current assets held.
In conclusion, a careful investor does not base his assessment on any single metric alone. It is the overall assessment of a company based on many factors of consideration that matters because considering any single metric in isolation may result in an inaccurate judgement of a company's investment worthiness.
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