Equity and capital refer to separate, but related, aspects of a company’s finances. Capital is the amount of money available to a business for investment, and is part of a business’s overall equity. Equity itself is a company’s total assets once associated liabilities have been deducted. Shareholders can contribute capital and own a share of equity.
Equity and working capital
Equity and working capital are even more closely related. Working capital is the amount left over for reinvestment once current liabilities (e.g. accounts payable) have been deducted from current assets (e.g. cash, accounts receivable, etc.).
Simply put, working capital is an indication of a company’s short term health, while equity is indicative of its overall value.
The working capital ratio
The working capital ratio is calculated by dividing a company’s current assets by its current liabilities. Understanding working capital as a ratio can be more useful than knowing its actual value as the ratio can indicate how efficient a company’s processes are.
Let’s say that a business’s working capital rises from £1,000 in year 1 to £1,500 in year 2. In terms of those numbers alone, it looks like the company is being more successful, having 50% more working capital available than the previous year.
However, we might look at the ratio and see that it has risen from 1.5 to 2.25. This is a cause for concern, because it suggests that the business is no longer investing their assets as much as they could be.
Alternatively, if we saw the same jump from £1,000 to £1,500, but the company’s ratio dropped from 1.5 to 1.1, we might be concerned. A drop in the working from one year to the next might be nothing to worry about, but if this trend continues and the business finds itself with a ratio of 1 or less, they could be in trouble.
In very broad terms, businesses should be aiming for a working capital ratio of between 1.2 and 2. A working capital of less than 1 means a business’s current liabilities are outweighing its current assets, and a ratio of more than 2 could indicate poor investment planning. Both are a cause for concern.
Days working capital
Days working capital is a useful application of working capital. It is calculated by multiplying average working capital by 365, then dividing the total by annual sales revenue. The final number indicates how long it takes to turn capital into revenue.
Days working capital is a metric used to determine how efficient a business’s processes are. Like we saw with the working capital ratio, trends up or down with days working capital can be used to analyse how well a business uses its assets.
One caveat to bear in mind is that what counts as a good days working capital figure varies by sector. For businesses in one industry, the benchmark figure could be completely different to another company doing something different.
Generally speaking, however, a lower number and a downwards trend are both desirable. This is because those figures would indicate that it’s taking less time to convert capital to revenue, giving shareholders a quicker return on their investment. A higher figure or an upwards trend can indicate the opposite: that the company is becoming less efficient in its revenue-generating processes.
Understanding working capital and equity for long-term planning
The advantage of understanding what working capital and its associated figures are, and how they relate to your business’s total equity, is that you’ll be able to plan for the future more intelligently.
Analysing trends in the working capital ratio and days working capital will help you to understand where your business’s processes could be improved, which will lead to a more successful business in the long run. The aim being, of course, to increase equity by growing the total value of your assets faster than your liabilities.
If you can do this successfully then you and any other investors could start to see some very satisfying numbers on your balance sheet.