So what is working capital?

Working capital is the money a company needs to operate on a day-to-day basis. It is an important number for investors to understand. As with most things, the best way to try and understand it is with an example.

Below is the balance sheet of Fevertree Drinks (FEVR), a maker of upmarket tonic water. I'll show you how to work out its working capital.

In order to sell its tonic water, the company needs to hold stock to ship out to customers. The money that it costs to make this stock is recorded on the balance sheet. You can see that Stock & WIP (Work in progress) at the end of 2015 was £6.4m.

Fevertree sells the tonic water to its customers on credit, meaning that they do not pay when they immediately receive it. At the end of 2015, Fevertree had Debtors of £16.8m. This was made up of £15.6m owed by customers and £1.2m of Prepayments. Prepayments are bills that have been paid in advance (in effect they are a credit against future expenses).

Then there was cash of £17.6m. If we add the cash to the debtors, prepayments and stocks we get a total of £40.8m of Current assets. These are assets that are cash or expected to be turned into cash within one year.

This £40.8m is tied up in the business. It isn't being used elsewhere or paid out to investors. It is a meaningful number.

Fevertree can offset this £40.8m by owing money to other parties. If we look further down its balance sheet we come to a section called Current liabilities. These represent money the company owes and which has to be paid within one year.

We can see that its suppliers (Trade creditors) were owed £4.1m. Accruals - expenses which apply to the current period but will be paid another - amount to £4.0m and £1.6m is owed to the tax authorities. If we add up the other current liabilities we get to a total of £12.1m.

If we take away the £12.1m of current liabilities from the current assets of £40.8m we get £28.7m. This is the company's working capital - an estimate of the money needed to operate on a day-to-day basis - to build and hold stock, wait for customers to settle their bills, and money on hand to pay suppliers.

Companies can have negative working capital and this occurs when the company's current liabilities are greater than its current assets (e.g. its credit terms are longer than those it extends to its customers) For example, a supermarket may pay its egg supplier on a 60 day basis but will expect to convert its stock into cash very quickly.

Working capital and the financial analysis of companies

Working capital is an important number which can tell you some useful information when you are analysing companies.

The things that you need to keep an eye are the trends in working capital as a percentage of turnover. Turnover is the key driver of a company's stock, trade debtors and trade creditors.

SharePad calculates the following working capital ratios for you (on the Ratios tab). You can also create a financial chart for them.

• Stock as % of turnover
• Trade debtors as % of turnover
• Trade creditors as % of turnover
• Working capital as % of turnover

Let's take a closer look at Fevertree as an example of working capital analysis.

Fevertree sells bottles and cans of tonic water all over the world, so you would expect it to have some stock in its warehouses.

We can see here that Fevertree's stock was just over 10% of its turnover in 2015 and that the ratio has seen a reasonable decline from 2014. Back in 2011 it was just under 9% so it has increased a little since then but there have been no dramatic increases which is a good sign.

Remember, an increase in stock means more capital employed (more of a company's cash resources used up). A big increase in the amount of stock as a % of turnover can be a bad sign as it might take longer to turn it into cash. In order to do this a company might have to reduce the selling price of its stock which will lead to lower profits.

Retailers have this issue every year at Easter, Bonfire Night and Christmas when they need to avoid being left with unsold stocks of Easter eggs, fireworks and Christmas card. This stock either has to be held for another year (impossible for food items), sold off cheap or written off.

Let's turn to trade debtors as a % of turnover.

Fevertree has debtors equivalent to 24% of turnover. This is quite a big number and needs watching.

A company can offer more generous credit to its customers in order to boost sales. This is also quite normal for a young company such as Fevertree which is trying to grow quickly.

However, the more debtors a company has the bigger the possibility that some of them will go bad. Customers might not pay their bills in full or at all. These outstanding debtors will need to be written off which will reduce company profits.

Fevertree can try and offset the working capital tied up in stocks and debtors by taking longer to pay its trade creditors and increasing them as a % of turnover.

As we can see in the chart below, this ratio has remained quite stable but did increase in 2015, suggesting that Fevertree might have gained some bargaining power with its suppliers to help finance its business.

Some things to consider

Comparing working capital as a % of turnover and calculating working capital days is a useful thing to do and something that makes you better informed. However, the ratios need to be interpreted with care.

The amounts of stock, debtors and creditors are all based on values at the end of the year whereas turnover is generated throughout the year. Year end balance sheet values might not be representative of levels of working capital throughout the year.

As I mentioned earlier, the quality of stock and debtors can also be an issue which can lead to reductions in profits.

To sum up

• Working capital is the amount of cash a company needs to manage its short-term commitments (stock, debtors and creditors). The lower the better.
• The less cash tied up as working capital, the more capital the company can dedicate to generating profit and thus higher returns (ROCE).
• Increases in stock and/or debtors are higher risk and can lead to lower profits.
• Trends in working capital as a percentage of turnover can give you insights into how a company is performing and also helps you compare companies (particularly sector peers).
• The working capital cycle tells you how quickly the company turns over this cash and is a sign of efficiency. The quicker the better.
• Changes to working capital can significantly affect free cash flow - a popular and important measure of company performance.
• An improvement to working capital (e.g. a reduction in debtors) which increases free cash flow will probably be a one-off event because you can only squeeze stock, debtors and creditors so far. Free cash flow may fall the following year.