PART 2
Working Capital Metrics
If you are working in treasury, there are fundamental metrics you need to be familiar with. These metrics are used to assess the effectiveness of working capital management, which will tell you what the firm’s default risk is — the risk that the firm won’t be able to pay its creditors.
These metrics are also used internally to assess the company’s performance, adjust payment terms, forecast cash flows and manage liquid resources. When you understand the company’s working capital position, and its funding requirements, then you as a treasurer have the information you need to make strategic decisions that include short-term investments, borrowing, credit terms and resource allocation.
There are a few things you will want to keep in mind when analyzing the metrics. First, there is no right or wrong number for a particular metric. Second, determining the metric’s trend is important, as is understating the factors underlying the trend. And finally, remember that metrics vary by industry and by country, so be sure to compare like to like — same industry, same country.
The fundamental working capital metrics are:
Net Working Capital (NWC) is figured by subtracting the total current liabilities from the total current assets. It is never a ratio, but rather an absolute measure. What the NWC tells you is, if all the company’s assets were converted to cash, it would have X amount more than is needed to pay off its current liabilities.
For example: $8,000 (current assets) - $3,400 (current liabilities) = $4,600 net working capital.
Current Ratio is figured by dividing the total current assets by the total current liabilities. What this figure tells you is the degree to which a company’s current obligations are covered by its current assets.Calculating the working capital ratio (aka current ratio) provides insights into a company’s short-term financial health, indicating its ability to cover short-term liabilities with short-term assets.
For example: using the same figures as above, we would have $8,000/$3,400 = 2.35. What this tells you is that the company carries $2.35 of current assets for every $1 of current liabilities. The higher the current ratio, the lower the default risk for creditors.
Quick Ratio (also known as the acid test ratio) is figured by figuring the sum of cash, short-term investments and accounts receivable and dividing that number by the total current liabilities. Just like with the current ratio, the higher the quick ratio, the lower the risk for creditors.
For example: $1,500 (cash) + $1,300 (short-term investments) + $1,700 (A/R) / $3,400 (current liabilities) = 1.32
The company has $1.32 in liquid assets for every $1 of current liabilities.
Days Cash Held is figured by dividing cash by operating expenses minus noncash expenses, divided by 365:
Days Cash Held = Cash / ((Operating Expenses – Noncash Expenses) / 365)
What this metric tells you is the measure of the company’s liquidity, or when the company will run out of cash, assuming operating expenses are paid on time and no additional revenue comes in. Of note, noncash expenses such as depreciation are excluded from the calculation.
For example: $1,500 (cash) / [$4,000 (operating expenses) - $200 (noncash expenses) / 365] = 144 days
However, this 144-day figure is not clear cut. The operating expenses are taken from the income statement, and are therefore treated as an average in the calculation. You would need a more detailed assessment of when operating expenses are due to achieve a more accurate figure. For example, if a major expense is due soon after the balance sheet date, the days cash held figure may be masking a potential cash shortage. By that same logic, if most major expenses are due shortly before the next balance sheet date, then days held cash would be understating the company’s cash position.
