Working Capital

How do trade creditors analyze the balance sheet and income statement? This topic concerns three calculations that the veteran credit analyst is likely to use as a starting point. It shows how to determine a company's [a] working capital, [b] its current ratio, and [c] its quick ratio. It also explains what these figures can tell you about a customer's financial strength.

When studying a commercial credit applicant's balance sheet, one key question to consider is: "How well is this firm able to meet its current debts?" To the beginner, it may seem logical that the answer to this question would lie in the capital (net worth) figure since this represents the excess of total assets over total liabilities. The fact is that best indicators of immediate credit strength involve:

[a] How the firm's assets are divided between the current and non-current categories, and
[b] In the relationship between current assets and current liabilities.

Consider, for example, the balance sheets shown here of firms A and B. They have identical net worth figures of $15,000. But notice that, while Company A has $30,000 in current assets with which to meet $15,000 in current liabilities, Company B must meet $20,000 in debts with $25,000 in current assets. Company A, in other words, has an excess of $15,000 in current assets over current liabilities as opposed to $5,000 for Company B.

This excess of current assets over current liabilities is called working capital (or, sometimes, net working capital). It is always determined by the following formula:

Current Assets - Current Liabilities = Working Capital
Co. A $30,000 - $15,000 = $15,000
Co. B $25,000 - $20,000 = $ 5,000

While an important factor in judging the credit strength of a firm, the working capital figure must be considered in the perspective of the overall balance sheet. Just how much working capital is enough depends, among other things, on the size of the company and the size of total current assets and total current liabilities. Consider, for example, this comparison between current figures for Company A and for larger Company C:

Each company has $15,000 in working capital. But while Company A has $2 in current assets per dollar of current liabilities, Company C has only $1.20.

If for some reason Company A's assets were to shrink by 50% to $15,000, in theory all of its current liabilities could still be paid through the liquidation of its current assets. But if Company C's current assets shrunk by the same 50% to $45,000 then current liabilities would be $30,000 higher than current assets. This situation would clearly be a concern to unsecured creditors.

The adequacy of any company's working capital, therefore, depends on the relationship between current assets to current liabilities [as measured in the current ratio] and not necessarily on the dollar amount of working capital.

The Current Ratio

You determine the current ratio [sometimes called the working capital ratio] by dividing total current assets by total current liabilities:

Company B, its net worth notwithstanding, has a considerably lower working capital ratio (1.25 to 1) than Company A (2 to 1). This tells you that all things being equal you would be safer in extending credit to Company A than to Company B. However, the current ratio does not necessarily tell you that Company B is a bad risk or, for that matter, that Company A is a good risk.

Ratios vary widely between different lines of trade, and also within a particular line for manufacturers, wholesalers, and retailers. Ratios vary from year to year depending on general business conditions. For any ratio to have real meaning, you must know how it compares with the financial ratio for companies similar to the one that you are evaluating. Comprehensive tables of ratios are published for each industry by the Dun & Bradstreet Company®, among others.

Even when you judge a working capital ratio in terms of those normal for the line of trade, it may have serious shortcomings as an indicator of the company's credit strength. The most serious of these shortcomings is the fact that all current assets are treated as having the same liquidity. However, various current assets have different degrees of liquidity. For example, accounts receivable is less liquid than cash, and inventories are less liquid than accounts receivable. Thus, a company with its current assets heavily concentrated in inventory is less liquid--and therefore in a weaker credit position--than a company with its current assets concentrated in cash or even accounts receivable.

A glance at Company B's balance sheet suggests just such a problem. And the quick ratio (or acid test) tells you exactly how serious this problem is.

The Quick Ratio

To determine the quick ratio, divide quick assets (cash and accounts receivable, but not inventories) by current liabilities:

This calculation tells you that for every dollar in current liabilities, Company B has only 45 cents in current assets. In contrast to this, all of Company A's current liabilities are "covered" the stated value of its quick assets:

A rule of thumb is that a quick ratio of 1 to 1 or higher is considered to be good. If the quick ratio is higher, so much the better.

Be careful not to use the quick ratio as too rigid a tool in making a credit decision. In many industries, businesses inventories vary seasonally. The quick ratio can vary right along with changes in inventory. Even a company that is an excellent credit risk that operates in a seasonal business is likely to show a low quick ratio at the beginning of its selling season when its inventory level is highest.