Your Money: How to compute working capital for target firms

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June 25, 2021 1:00 AM

Compute non-cash working capital for past five years to understand the trend and use it to predict its future course

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

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

Hypothetical illustration
Let us assume the following figures (amount in Rs crore) for Sharad Tejas Ltd (ST) for its latest financial year: Current assets 600; Trade receivables 200; inventories 300; cash and cash equivalent 50; other current assets 50; current liabilities 400; trade payables 140; accrued expenses 60; current portion of long-term debt 100; short-term bank loan 50; other current liabilities 50; total assets 700; long term debt 200; shareholders’ funds 100; sales revenue 1,000.

Working capital refers to the requirement of funds for meeting the operating activities of an entity.

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

This definition is not rational as it considers cash and cash equivalent in the working capital computation. Cash and cash equivalents are already in the liquid form with the firm and hence it should not be considered in the computation of the requirement of funds. Further, WC is dealing with requirement of funds invested in unproductive assets. For instance, ST has blocked capital of Rs 500 crore in trade receivables and inventories which are yet to be realized in cash and the firm pays the cost of this Rs 500 crore till the time it is realised in cash. However, cash and cash equivalents are productive assets as the firm invests it in avenues that are expected to earn the required rate of return. Therefore, we should exclude cash and cash equivalent in the computation of WC.

Further, conventional practice of considering the entire amount of current liabilities in the computation of WC is not appropriate as it considers interest bearing current liabilities such as short term borrowings and current portion of long term debt (i.e., principal amount of long term borrowings which are due for payment in the next 12 months). These are already included in the computation of cost of capital. Therefore, to avoid double counting, we should exclude interest bearing current liabilities in computing WC.

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

One could compute the non-cash WC of a firm for the past five years to understand the trend and use it for predicting the WC for its future.

The writer is associate professor of Finance at XLRI – Xavier School of Management, Jamshedpur

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