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Working capital analysis is one way of evaluating the credit worthiness of a business. By evaluating changes in a firm’s current assets or liabilities, an analyst can determine changes to the business’ working capital. This figure helps lenders determine how much financing will be required to see a business through its normal cycle of operation.
Determining the amount of a business’ working capital typically is a process of subtracting its current liabilities from its assets. Working capital is the amount of assets a business has on hand to see it through the time after which a product is acquired and sold but before the business has collected on the sale. The more working capital a business has, the less it needs to borrow for routine operations and the better credit risk it poses.
An important step in working capital analysis is to review changes in a firm’s net worth. A simple definition of net worth is total liabilities subtracted from total assets. If the net worth figure increases, a business should have more working capital. A lower net worth mean less working capital.
Since working capital analysis is based on a firm's current assets and liabilities, as opposed to total assets and liabilities, long-term debt is not considered. That means an increase in long-term debt can yield an increase in working capital. One of the purposes of working capital analysis is to uncover just such circumstances so that business owners or lenders know when an apparent working capital increase might in fact also represent an increase in liabilities that must be paid from future earnings.
Working capital can also increase as a result of non-current assets being depreciated over time. This is a normal result of business operations as plants and equipment lose value the older they are. The resulting increase in working capital is not actually more cash on hand for the business. This information, once again, is important for lenders as the increase in working capital might not indicate an increased ability to repay loans.
Analyzing working capital needs is also a matter of understanding a company’s normal business cycle. Seasonal businesses such as holiday retailers spend heavily in late summer and early fall but often do not collect on sales resulting from that money spent until late fall and winter. Working capital analysis helps a business and its lender understand how well the business can bridge that gap, how much the business can pay from its own resources, how much it will need to borrow and how worthy the firm is to repay.
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