Your Money: How to Calculate Target Business Working Capital

Working capital is a key result area (KRA) for companies operating in the manufacturing and trade sectors. Therefore, it is prudent to know how to calculate the working capital of target companies for investment.

hypothetical illustration
Assume the following figures (amount in Crore Rupees) for Sharad Tejas Ltd (ST) for its last financial year: Current assets 600; Trade receivables 200; inventories 300; cash and cash equivalents 50; other current assets 50; current liabilities 400; trade payables 140; accruals 60; current portion of long-term debt 100; short-term bank loan 50; other current liabilities 50; total assets 700; long-term debt 200; equity 100; turnover 1000.

Working capital refers to the need for funds to meet an entity’s operating activities.

Conventional working capital
Working capital is defined as the excess of total current assets over total current liabilities of a business. For ST, it is Rs 200 crore. As a percentage of total assets, the WC for ST is 28.57% and it accounts for 20% of sales.

This definition is not rational because it takes into account cash and cash equivalents in the calculation of working capital. Cash and cash equivalents are already in liquid form with the company and should therefore not be taken into account in the calculation of the need for funds. Also, WC takes care of the requirement of funds invested in non-performing assets. For example, ST has locked capital of Rs 500 crore in trade receivables and inventory which is yet to be realized in cash and the company is paying the cost of this Rs 500 crore until such time as it is realized in cash. However, cash and cash equivalents are earning assets because the business invests it in avenues that are expected to earn the required rate of return. Therefore, we must exclude cash and cash equivalents in the WC calculation.

In addition, the conventional practice of considering the total amount of current liabilities in the WC calculation is not appropriate because it considers interest-bearing short-term liabilities such as short-term borrowings and the current portion of the long-term debt (i.e. the principal amount of long-term borrowings that are due within the next 12 months). These are already included in the calculation of the cost of capital. Therefore, to avoid double counting, we must exclude interest-bearing current liabilities in the WC calculation.

Non-cash working capital
This is the excess of non-cash current assets over non-interest bearing current liabilities. For ST, it is Rs 300 crore. As a percentage of total assets, ST’s non-cash WC is 42.86%, and it accounts for 30% of sales.

One could calculate a company’s non-cash WC over the past five years to understand the trend and use it to predict the WC for its future.

The author is Associate Professor of Finance at XLRI – Xavier School of Management, Jamshedpur