Learning Mathanese: How to Calculate Working Capital
Sep 28th 2011 8:15PM
Updated Sep 28th 2011 8:22PM
Math. A four-letter word you can say on TV, yet so reviled that people go to great lengths to avoid it, even when they know that doing so puts their financial well-being in peril.
Wait! Don't click away. Today brings part three in a continuing series that spotlights the major computations found here at AOL DailyFinance. Or, as we'll call it, a short course in Mathanese -- aka the numbers behind investing's (and life's) big equations.
Last time, we covered market cap and enterprise value. Today, we move on to the all-important working capital.
How Strong Is Your Stock?
Working capital is like a bank account. Companies with more working capital have, well, more capital to work with. They're stronger than their peers because they have more resources to fund growth.
Berkshire Hathaway (BRK-A)(BRK-B) chairman Warren Buffett knows more than a little about the metric. His teacher, the legendary investor Benjamin Graham, would seek stocks that traded for a discount to their liquidation value on the theory that even distressed businesses would attract buyers at the right price. Working capital is key to knowing liquidation value. (In part, because of its own generous working capital, Berkshire can spend tens of billions on repurchasing shares of its own stock.)
How to figure it? Easy: Working capital is derived from the balance sheet and equals the sum of current assets such as cash and inventory after subtracting current liabilities such as accounts payable and short-term borrowings. Here's the math:
[Current assets - current liabilities]
And here's the equation when you plug in the numbers for an industrial manufacturer such as Ford Motor (F), which as you'll see is almost as cursed with obligations as it is blessed with assets:
[$122.768 billion - $98.927 billion] = $23.841 billion
Why You Should Care About This Metric
Working capital is an important metric because of what it says about management's ability to deploy capital for expansion or acquisitions. Think of it like you would Major League Baseball's disabled list. The current roster and last year's stat sheet for your favorite team may project a winner, but what happens if the star outfielder's penchant for hitting 50 home runs suddenly disappears because of injury?
When working capital goes missing via reckless spending or an unforeseen cost, good businesses get hobbled and investors pay the price.
Have questions or comments? Send Tim an email.
Motley Fool contributor Tim Beyers is a member of the Motley Fool Rule Breakers stock-picking team. He owned shares of Berkshire Hathaway at the time of publication. Check out Tim's portfolio holdings and other columns, or connect with him on Google+ or Twitter, where he goes by @milehighfool. Motley Fool newsletter services have recommended buying shares of Ford Motor and Berkshire Hathaway.