There’s a subtle difference between working capital and current ratio. Though both can be calculated from the same place in the balance sheet, they are not one and the same.
Working capital and current ratio paint two separate pictures about a business. To understand those pictures, we need to know the subtleties of each formula.
In this post, we’ll cover the following key parts of the differences between working capital vs current ratio:
- The Basics of the Current Ratio
- The Basics of Working Capital
- How Retailers Use Working Capital in Their Business
- How Working Capital Gets Managed Like Any Other Investment
- Working Capital and Free Cash Flow
- Investor Takeaway
First, let’s define the current ratio formula.
The Basics of the Current Ratio
Both line items for the current ratio are found in every company’s consolidated balance sheet inside the company 10-K.
In general, the current ratio tells you how much liquidity a company has.
Common line items you’ll see under current assets include:
- Cash and cash equivalents
- Accounts receivable
- Short term investments
Common line items you’ll see under current liabilities include:
- Accounts payable
- Accrued liabilities
- Short term debt
Current assets and current liabilities represent those items which are short term in nature — those within 12 months or less.
Depending on what kind of business model a company has, certain line items will be less or more important than others.
For example, accrued liabilities are usually of chief concern if a company runs a subscription business. They represent the remaining expenses to serve a customer who has paid upfront.
On the other hand, a company like a retailer probably doesn’t have much in accrued liabilities but might carry heavy inventory, due to having a large store with many items.
In general, a company with a higher current ratio is seen as more liquid, since a higher current ratio means more current assets than liabilities.
A company with a lower or negative current ratio might be perceived as more risky, though that’s not always true as we’ll discuss later.
The Basics of Working Capital
Working capital represents the amount of short term capital a company needs to run its operations continuously.
You’ll often see working capital simplified as Current Assets – Current Liabilities. In this definition, the more current assets a company has, the higher its “working capital.” And if a company has more current liabilities than current assets, then it has “negative working capital.”
This isn’t always an accurate representation, however.
You see, sometimes companies will stockpile cash for several reasons. Maybe the company sees a liquidity crunch ahead. Maybe the company just had a huge inflow of revenue and/or is investing less into inventory for future growth. Maybe the company is just ultra conservative.
Because of all of these possible reasons a company might keep excess cash, it’s not uncommon to see excess cash on a company’s balance sheet. This pushes up current assets and the current ratio, but doesn’t mean a company has high working capital needs.
While a high current ratio can be seen as positive because it implies great liquidity, a high working capital is sometimes referred to in a negative light on Wall Street because it represents high investment needs (in other words, a company who needs short term capital/liquidity).
That doesn’t really make sense since both ratios are basically calculating the same thing, which can be confusing for beginners.
That’s why we need to calculate working capital in its more subtle form:
Or, how I prefer it:
To understand why working capital should be calculated in this way, I think it helps to understand an example.
Let’s go back to the retailer again.
How Retailers Use Working Capital in Their Business
Think about a retailer like Walmart, Target, or Costco for a minute. While these retailers might have their own private label brands, they generally sell a majority of their products from third parties.
Each store might carry Pepsi, Coke, and Dr. Pepper in their soda aisles. They might sell Apple iPhones and Samsung Galaxy smartphones, and sell Charmin toilet paper and Tylenol pills.
What a retailer like Target provides for these third party brands is heavy foot traffic, which translates to high volume. That high volume allows the third parties to mass produce their products and operate a successful business.
Customers love retailers because they can go to one place to fulfill a multitude of buying needs.
Now, as these suppliers and retailers interact with each other in large volumes, it’s not easy enough to just pay cash or card like a normal consumer would.
Having Visa or Mastercard take heavy fees from each transaction isn’t the most efficient way to handle payments between suppliers (vendors) and retailers (buyers). So, many vendor-buyer relationships use an element of supplier credit. In this case, the goods or service is delivered and the buyer has 10, or 30, or 45+ days to pay for it later.
These types of supplier credit show up on company balance sheets as Accounts Receivable and Accounts Payable. They will be turned into cash in the near term.
These are real, short term capital needs for businesses dealing with physical products. And how that changes from year to year isn’t always as simple as how much a company is buying or selling.
How Working Capital Gets Managed Like Any Other Investment
Good companies have an executive who manages working capital and uses it to the company’s advantage when they can.
As investors, we know that time is money.
Idle cash isn’t always the best use of money, and if it can be invested to make more money, then it makes sense for many companies to do that.
Nobody understands this better than banks. They take customer deposits and then invest that idle capital back to other customers in the form of loans.
Warren Buffett was also an investor who built his empire based on the idea of investing idle capital.
The insurance business can be excellent for managing capital because customers pay insurance companies upfront in the form of premiums. Customers may or may not receive large payouts down the line in an accident as a claim. The upfront capital is referred to in the industry as “float.”
Well just like insurance companies can earn excess returns on float, companies with huge buying power can free up working capital, which can work as a free sort of short term loan and increase long term free cash flows.
When Negative NWC Unlocks Higher Free Cash Flows
A great example of a company with Net Working Capital unlocking Free Cash Flow is Amazon.
In 2021, Amazon had the following metrics:
- Accounts receivable = $32,891 million
- Inventories = $32,640 million
- Accounts Payable = $78,664 million
- NWC = (32,891 + 32,640) – 78,664 = -$13,133 million
Notice that the company’s NWC is negative. A big reason for their ability to operate with negative Net Working Capital, which unlocks Free Cash Flow, is because of their significant buying power.
For many of the company’s third party vendors, Amazon is the only game in town for them. Because of this, they have to play on Amazon’s terms.
Playing on Amazon’s terms might mean accepting lower margins. It can also mean extended credit terms for when Amazon pays its vendors.
If Amazon is able to continue to flex its negative NWC through the years, then the company has essentially found a free source of financing.
Each year, the company essentially gets an interest-free loan on sales on its platform. It allows the company to be more aggressive with its long term investments. It adds flexibility.
When Working Capital Is a Drain (Investment Needs)
Now, most companies don’t have the same luxuries as Amazon. They can’t just bend vendors and customers to their will in regards to credit and financing windows.
Most companies must fund growth through investments in working capital. The problem is that these proportionally increase as a company gets bigger.
For example, a humble ice cream stand would need to buy more ingredients and supplies if it wants to satisfy increased demand and earn higher revenues and sales.
This costs money, or in other words, investments in working capital.
As we take that application into valuing businesses, we need to understand that just as working capital can be an asset for an investor in Amazon, it can be a curse to a rapidly growing business. To calculate that requires learning NWC’s relationship with Free Cash Flow.
Working Capital and Free Cash Flow
Calculating changes in working capital is a key component in estimating a company’s Free Cash Flow. It is presented on every company’s cash flow statement under Cash From Operations.
As Aswath Damodaran and other great business school professors teach, a company’s cash flows must be invested in the following two (or three) categories to attain future growth:
- Working Capital Investments
- Capital Expenditures
In a basic Discounted Cash Flow (DCF) model, these required investments are baked into the formula automatically.
Working capital investments are included in a future free cash flow estimate by being a part of current FCF estimate. For example, Changes in Working Capital is included in Cash From Operations, which is used to calculate FCF.
But, there’s another way to estimate a company’s investment needs, which is especially critical for a company with unique or constantly changing NWC.
Normalized Working Capital Investment
First, we need to understand that working capital investments and capital expenditures are taken from NOPAT (Net Operating Profit After Taxes). Estimating capital expenditures is an easy part, since as a general rule they are on a single line-item on the cash flow statement and aren’t subject to as much variation as changes in working capital.
Damodaran relayed a simple yet effective way to estimate a company’s working capital investment needs with the following formula:
Of course, we want to calculate NWC with my more detailed definition including accounts payable, receivable, and inventory.
Then we normalize it over several years, by taking the average.
Finally, we want to project revenue growth over several years (which I discussed in-depth here), and then use that revenue number and our normalized NWC-to-sales ratio above to estimate future working capital investment needs.
If a company has demonstrated an ability to sustain negative NWC for several years such as Amazon, then maybe we disregard working capital investment needs. This can then boost future FCF estimates, but it should be done carefully.
Make sure you are taking NWC investment and capex from NOPAT and not from the traditional definition of FCF, as that would double count changes in working capital.
As you can see, the difference between the working capital vs current ratio calculations are slightly different. Sometimes, highlighting these can uncover a business with a competitive advantage.
It can also help us to make better future free cash flow growth projections and intrinsic value estimates.
Like with all stock analysis, take it on a business-by-business basis. Seek to understand rather than rush to hasty conclusions based on what the numbers are telling us.