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 is one of those formulas that is often quoted incorrectly, and it’s also because of a subtle difference.
Finally, working capital and current ratio paint two separate pictures about a business, and to understand those pictures we need to know the subtitles 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.
Current Ratio = Current Assets / Current Liabilities
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—usually within 12 months or less.
Depending on what kind of business model a company has, there will be line items which are more or less important than others.
For example, accrued liabilities are usually of chief concern if a company runs a subscription business and takes annual payments, as they represent the remaining expenses to serve a customer which the customer 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. Working capital uses the same section of the balance sheet that the current ratio does, which are line-items embedded in current assets and current liabilities.
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 which 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:
= (Current Assets – Excess Cash) – (Current Liabilities – Short Term Debt)
Or, how I prefer it,
Net Working Capital (NWC)
= (Accounts Receivable + Inventory) – (Accounts Payable)
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. We know that while each company might have some of their own private label brands—Costco’s Kirkland Costco’s Kirkland comes to mind—these retailers in particular sell a majority of their products from third parties.
Each of the retailers 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, which allows the third parties to mass produce their products and operate a successful business.
Customers love retailers because they don’t have to go to a toilet paper shop and soda shop and a phone shop etc, etc, they can go to one place, like a grocery store or a multi-product channel retailer like Target to fulfill a multitude of needs in one convenient trip.
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.
After all, having warehouses full of cash and Visa/Mastercard taking 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, where 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, since they aren’t immediately translated into cash.
It’s a definite need for running a business, but how that working capital 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
Just like a CFO or CEO might be responsible for allocating a company’s long term capital spending and long term investments, someone in the company needs to manage working capital and use 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, who take customer deposits and then invest that idle capital back to other customers in the form of loans, making a spread on the money that’s loaned to the bank and the money they loan to customers.
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, and may or may not receive large payouts down the line in an accident as a claim. This 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 increased 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 2020, Amazon had the following metrics:
- Accounts receivable = $24,542 million
- Inventories = $23,795 million
- Accounts Payable = $72,539 million
- NWC = (24,542 + 23,795) – 72,539 = -$24,202 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 the gigantic online retailer 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, which allows the company and investors to benefit from quicker long term investments and greater short term liquidity, which adds flexibility.
In theory, the company could even invest their working capital “float” at attractive short term rates to add another revenue stream—one that is possible simply because of its competitive advantages which have led them to being the dominant eCommerce channel for selling to the average consumer.
When Working Capital Is a Drain (Investment Needs)
Now, most companies don’t have the luxury of an Amazon to bend vendors and customers to their will in regards to credit and financing windows.
For most companies, they must fund growth through investments in working capital, which 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, and 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, as it is presented on every company’s cash flow statement under Cash From Operations.
As Aswarth 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
- (For some companies): Acquisitions
In a basic Discounted Cash Flow (DCF) model, these required investments are baked into the formula automagically.
Working capital investments are included in a future free cash flow estimate by being a part of current FCF estimate.
One of the most common implications of FCF is Cash From Operations – Capital Expenditures, and since Changes in Working Capital is included in Cash From Operations, we can see that Investment Needs #1 and #2 for growth are already part of FCF.
From there, an investor/analyst can just estimate a growth rate, and the reinvestment needs of the business is already considered and finds its way into the valuation.
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:
=Normalized NWC / Sales
Of course, we want to calculate NWC with my more detailed definition including accounts payable, receivable, and inventory—which ignores other current line-items that might distort the standard WC formula.
Then we normalize it over several years, simply 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 and therefore boost future free cash flow estimates, but this 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. I recommend again reading through my in-depth guide on projecting future cash flows, where I cover that extensively).
I hope our in-depth discussion on Working Capital and NWC has provided clarity into why the difference between the working capital vs current ratio calculations are slightly different, but can provide a peek into the competitive strength of a business (compared to others in its value chain).
We can also use our knowledge about NWC to interpret changes in Free Cash Flow from year-to-year, and make intelligent conclusions based on the numbers.
For example, if a company invests heavily in inventory because it anticipates high upcoming demand, this will cause NWC to rise and push FCF down (since cash is spent to increase working capital), and can make a company look more expensive on a FCF basis than it might really be. Especially if high upcoming demand is sustained, you might find a great investment opportunity there that others might be frowning on because of the decrease in FCF.
Also, calculating NWC can give us better clarity than the vanilla version of the Working Capital formula and the Current Ratio; if NWC suddenly decreases because a retailer sells out of its inventory (and customers pay cash), we might recognize this as a positive catalyst even though the Current Ratio stays constant (as the decreased inventory simply converts to cash and doesn’t change Current Assets).
I hope we all can use these lessons about working capital to make better future free cash flow growth projections and intrinsic value estimates.
Like with all stock analysis, take it business-by-business, and seek to understand rather than rush to hasty conclusions based on what the numbers are telling us.