How I think about Working Capital

Working capital should only include inventories, receivables, other current assets
(including cash) required for running the business at current levels of business
volumes. Cash which is surplus to running the current scale of operations (whether
kept as cash or parked in investments) should be excluded. Care should taken
about seasonality. In some businesses, because of their seasonal nature, the need
for cash grows during certain months of an year and then falls. In such situations if
seasonally surplus cash is parked in investments, it should still count as a working
capital item.

One should deduct current liabilities pertaining to amounts due to vendors (but not
for fixed assets), advances from customers and other payables for running the
operations. Items like provision for taxes, proposed dividends, debt due within next
one year should not be considered for computing working capital.

I use this definition of working capital for estimating the working capital intensity of
a business. I do this by comparing the average working capital needed in a year
with net revenues of that year. More insights are often found by looking at the trend
of working capital intensity over a number of years.

If, instead of measuring working capital intensity, one is testing short-term

solvency, then all liabilities which are due within one year (e.g. short term debt,
payables for fixed assets) should be counted and all cash items including
investments should also be counted. I hardly use this version of the ratio, however,
because I focus on exceptionally well financed businesses and there are other
ratios to figure that out.

Sanjay Bakshi