Friday, November 6, 2009

Liquidity Analysis Part 1: Net Working Capital

The term liquidity can be interpreted in various ways, depending of course upon the specific circumstances. In corporate financial accounting, liquidity refers to the firm's ability to pay its debts when they are due. The importance of possessing that ability should be self evident, as should the ability to evaluate a firm's liquidity position.

The first measure that you should be able to calculate is Net Working Capital:

Net Working Capital = Current Assets - Current Liabilities
Intel's 2008 Net Working Capital = $19,871M - $7818M
= $12,053M

In order to properly grasp the concept of Net Working Capital, you should be familiar with the two balance sheet accounts used to calculate it; Current Assets and Current Liabilities. Current Assets are basically those assets which are not necessarily long term in nature. It includes cash and cash equivalents, accounts receivable, and inventory held by the firm for sale. You should know however, that items like prepaid rent and prepaid insurance for the next 12 months also fall under Current Assets. Current Liabilities are short term notes payable, accounts payable, and the portion of long ter
m debt that is due within the year. That being said, it should be evident that the prepaid rent portion of Current Assets wouldn't satisfy the cash obligation portions of Current Liabilities. The point is, investors need to dig in a little bit to determine the actual quality of a firm's net working capital. Also, it can be instructive to compare a firm's changes in net working capital over time. The chart below serves that purpose for Intel Corporation (INTC):
From the chart above, I'm not sure whether any discernible trend can be declared. Most likely, Intel was making use of it's cash for investments/acquisitions from 2003-2006, thus lowering it's net working capital. Intel is not a highly leveraged corporation - relatively speaking - though, so I wouldn't be too concerned with these fluctuations. If however, we observed that net working capital was declining, and over the same period the firm's debt-to-equity ratio was rising, it might be wise to pause and examine just why this was occurring.

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