The higher a company’s working capital as compared to sales, the better off and more stable the company is financially. When sales increase but working capital falls, the company may have difficulty sustaining operations and purchasing inventory to fulfill new orders, and it may also experience other financial problems.
Working capital is calculated using the equation of a company’s current assets minus current liabilities. Observing a company’s existing working capital balance is the easiest way for investors to judge the amount of a company's assets that are easily liquidated. Liquid assets must be available on an ongoing basis to invest in building the company's business, funding future growth and increasing value for its shareholders
The working capital to sales ratio shows a company's ability to pay costs related to generating new sales without the need to take on additional debt. Although borrowing money to finance new equipment or other initiatives to help increase sales is not bad on its own, a company must still be able to easily pay down its debt and maintain enough liquid assets to finance the ongoing operations of the company. Conversely, if a company maintains an exceedingly high working capital to sales ratio, it may be holding on to too many assets that would be better used to finance new growth or additional sales.
The costs a company needs to cover in order to generate goods for sale are captured in the cost of goods sold — or COGS — line item on the income statement. This does not include general and administrative costs required to keep the company running. COGS is matched with sales in a given time period on the income statement. COGS includes the cost of raw inventory inputs to the manufacturing process, and may also contain wages for employees specific to the manufacturing process.
Financial statements that show negative working capital may be a sign of problems to come. Negative working capital means the company's liabilities exceed its assets, providing the company with very limited ability to spend as much on current operations and future growth as its peers who have positive working capital. When working capital continues to drop as a percentage of sales, the company may not have enough cash to pay its vendors or cover its debts.