The concept of working capital, also known as net working capital (NWC), does not apply to banks since financial institutions do not have typical current assets and liabilities, such as inventories and accounts payable (AP). Also, it is very hard to determine current liabilities for banks because banks typically rely on deposits as a source for their capital, and it is not certain when customers will demand their deposits back.
- Working capital is a measure of a company's financial strength and is calculated by subtracting current liabilities from current assets.
- Attempting to calculate a bank's working capital is impractical because a bank's balance sheet will not include typical current assets and liabilities, such as inventories and accounts payable (AP).
- A better metric to calculate a bank's financial health is net interest margin (NIM), which measures how much a bank earns in interest compared to how much it pays out to depositors.
Calculating Working Capital
Working capital is calculated as the difference between a company's current assets and current liabilities. Working capital is used to finance a company's current operations, such as purchasing inventories, collecting accounts receivable (AR) from customers, obtaining credit from vendors, and producing and shipping products.
Working capital is a measure of a company's financial strength. If a company has a negative working capital—meaning its liabilities are greater than its assets—the company may have trouble paying its short-term debts. It may have to borrow money to pay its debts or, in the worst case, it may go bankrupt. If a company has a positive working capital—meaning its assets are greater than its liabilities—the company has enough money to pay its short-term debts. This is a sign the company is working efficiently and profitably.
Working Capital and a Bank's Balance Sheet
Given the nature of a bank's business, calculating working capital is an impractical endeavor. A bank's balance sheet does not contain inventories or typical accounts payable. Banks do not produce physical goods. Instead, they borrow and lend funds. A bank's income comes primarily from the spread between the cost of capital and interest income it earns by lending out money to the public.
Also, banks do not have fixed assets, and they heavily rely on borrowing as their primary source of capital. This is especially evident from looking at a typical commercial bank's balance sheet. It has a small number of fixed assets, which primarily consist of various fixtures and buildings.
Another issue with calculating working capital for banks is a lack of a classification of assets and liabilities by their due dates. Banks do not organize their balance sheets by current and noncurrent assets and liabilities, as it is impossible to do so. For instance, a typical bank's liabilities consist of deposits, which can be withdrawn on demand. Because it is impossible to determine with certainty when a particular deposit will be demanded, banks have no means to classify deposits as either current or noncurrent. All this makes the classification of assets and liabilities by their due dates impractical.
Net Interest Margin (NIM) and Bank Profitability
Compared to working capital, calculating net interest margin (NIM) is a more straightforward way of determining a bank's potential for profitability and growth. The formula for net interest margin is investment returns minus investment expenses divided by average earning assets.
Banks and investment firms use net interest margin as a metric to show how successful they are at earning interest on their funds compared to the interest they pay their depositors. A positive net interest margin indicates a bank is making more money from its credit products (mortgages and loans, for example) than the interest it pays its depositor accounts (savings and certificates of deposit, for example). A negative net interest margin means a bank's investment expenses exceed its investment income, an indication the firm's management is not investing its funds effectively.