Welcome to professorsavings.com, we teach finance basics. Today we will teach you about working capital.
Hi I’m Rayfil Wong. We hope these investment concepts will help you be a better investor.
Working capital is a measure of a company’s financial strength.
Professor Savings is thinking about investing in the computer industry and he has his eye on two companies: Ali’s and Rick’s computers.
Professor Savings calculates the working capital for each company. Ali’s Computers has $200,000 in current liabilities. Tgese liabilities that the company must pay this year. At the same time, Ali’s computer has $300,000 in current assets.
Luckily, these assets that can be converted in to cash in less than a year.
Now, let’s do the simple math. $300,000 in assets minus $100,000 in liability means that Ali has $100,000 in working capital.
This means the company can easily pay down its short-term liabilities or debts using its current assets. This is a sign of a profitable and efficient business.
Great job Ali.
Rick’s computers on the other hand has $400,000 in current liabilities and only $300,000 in current assets, meaning the company a working capital of negative $100,000.
Negative working capital suggests that Rick’s Computer may have trouble paying its short-term debts. Rick might be forced to sell an asset or raise more capital through long-term debt like a bond or in the worst case, the company could go bankrupt because it can’t pay what it owes.
Since Rick’s Computer is working off negative working capital, Professor Savings chooses Ali’s Computer as the investment.
Working capital helps investors judge a company’s financial health and future prospects, but no single measure tells the whole story.
Remember, working capital is just one of many metrics investors use to evaluate a stock.