What Is Working Capital?
Working capital is an accounting measure that refers to the amount of liquid assets a company has to deploy over the next 12 months in relation to its short-term financial obligations for the same time period. It indicates whether the pool of money a company has, or expects to receive, over the next year is sufficient to meet the short term obligations it also expects to meet during that time.
Working capital is calculated as part of a company’s balance sheet and includes a company’s assets and liabilities over the next 12 months. While the equations for calculating working capital are straightforward, most businesses have considerable inflows and outflows of funds, many of which have some degree of uncertainty as to timing. That makes working capital a constantly evolving amount. However, keeping pace with its dynamics is important for those in the leadership and finance departments of a company to ensure that they are effectively utilizing their liquid assets and meeting their obligations.
How much working capital a company needs often depends on the industry and the way things are made, paid for, and sold in that industry. For example, companies in seasonal industries might need more working capital at the beginning of the season since they won’t get payments from customers until later in the season. Considerable working capital could also be required by businesses that need to leverage supplier discounts by buying or manufacturing in bulk to keep their margins low. To know how a company is performing this metric, it’s important to compare its working capital to the average in its industry.
Takeaway: Working capital is the amount a company has available in short-term liquid assets after its current short-term liabilities are paid. It determines a company’s immediate liquidity and is often used to manage cash flow and for other forms of financial analysis.
2 Components of Working Capital
Current assets and current liabilities are the two main components of working capital:
1. Current Assets
A company’s current assets include all its:
- Cash and cash equivalents
- Prepaid expenses
- Inventory that is expected to be sold within 12 months
- Marketable securities
- Supplies
- Accounts receivable
- Assets it expects it could liquidate within 12 months
It could also include less common assets like a piece of property a company is readying to sell, or the cash surrender value of life insurance.
Key Takeaway: Current assets represent the amount of liquidity a company has or will have on hand to pay expenses.
2. Current Liabilities
A company’s current liabilities are all the company’s obligations that will come due within 12 months of the balance sheet’s date. That could include all:
- Debt payments due
- Accounts payable
- Wages and payroll taxes
- Invoices
- Other taxes
- Customer deposits
- Deferred revenue
- Large purchases
It could also include less common expenses like bank overdrafts, dividends declared, and judgments against a company.
Key Takeaway: Current liabilities represent the total expenses a company will have to pay in the next 12-month period.
How Working Capital is Calculated
The working capital calculation is then taken by subtracting the liabilities form the assets as follows:
Working Capital = Current Assets – Current Liabilities
This equation finds the current amount a company has in working capital and is sometimes also called the net working capital formula.
However, net working capital can also be calculated in other ways, depending on how a particular industry likes to view it.
Alternative net working capital formulas include:
Net Working Capital = Current Assets (less cash) – Current Liabilities (less debt)
Net Working Capital = Accounts Receivable + Inventory – Accounts Payable
Working Capital Ratio (Current Ratio)
A financial officer at a company might also want to know how much the company has in working capital relative to the size of its liabilities to understand how robust a company’s pool of working capital is relative to its expenses. For this, a working capital ratio can also be calculated. The equation for that calculation is:
Working Capital Ratio = Current Assets / Current Liabilities
The working capital ratio (also called the current ratio) provides the percentage of the working capital surplus or shortfall compared to its liabilities or assets.
For example, if a company has $100,000 in current assets and $90,000 in liabilities, the company has a working capital of $10,000 but a working capital ratio of 110%.
$100,000 / $90,000 = 110%
If that company is in an industry where the average working capital of its competitors is 130%, then that company could face problems with growth or paying its bills if faced with an unexpected opportunity or expense.
Working Capital Example
Working capital isn’t a static number and can change over the year as outputs and inputs shift.
Finding Working Capital: Example
For example, assume Acme Corp’s current assets add up to $85,000 and current liabilities add up to $75,000.
$85,000 - $75,000 = $10,000
| Current Assets | $ |
| Cash | $10,000 |
| Accounts Receivable | $30,000 |
| Pre-Paid Expenses | $5,000 |
| Inventories | $30,000 |
| Short-Term Assets | $10,000 |
| Total Current Assets | $85,000 |
| Current Liabilities | $ |
| Accounts Payable | $30,000 |
| Debt Payments | $5,000 |
| Dividends Declared | $20,000 |
| Taxes | $20,000 |
| Total Current Liabilities | $75,000 |
| Total Current Assets | $85,000 |
| Total Current Liabilities | ($75,000) |
| Working Capital | $10,000 |
Change In Working Capital: Example 1
Then assume Acme Corp unexpectedly gets a big order of its widgets that requires they manufacture more goods which they must pay for in advance. Since they only have $10,000 in working capital, they decide to take out a loan for $50,000 so they have enough to pay for their order. However, they will receive $90,000 for the order in 6 months. Here is how the loan, expected accounts receivable and new manufacturing expenses shifts Acme Corp’s working capital calculation:
$225,000 - $125,000 = $100,000
However, you can also use the changes in working capital formula to calculate it if you want to understand how working capital shifts.
Changes in Working Capital = Changes in Current Assets - Changes in Current Liabilities
$140,000 - $50,000 = $90,000
| Current Assets | $ |
| Cash | $60,000 |
| Accounts Receivable | $120,000 |
| Pre-Paid Expenses | $5,000 |
| Inventories | $30,000 |
| Short-term assets | $10,000 |
| Total Current Assets | $225,000 |
| Current Liabilities | |
| Accounts Payable | $80,000 |
| Debt Payments | $5,000 |
| Dividends Declared | $20,000 |
| Taxes | $20,000 |
| Total Current Liabilities | $125,000 |
| Total Current Assets | $225,000 |
| Total Current Liabilities | ($125,000) |
| Working Capital | $100,000 |
Change in Working Capital: Example 2
However, once Acme Corp is paid for their goods, their working capital shifts again.
$175,000 - $125,000 = $50,000
Changes in working capital = Changes in Current Assets - Changes in Current Liabilities
$50,000 - $0 = $50,000
| Current Assets | $ |
| Cash | $10,000 |
| Accounts Receivable | $120,000 |
| Pre-Paid Expenses | $5,000 |
| Inventories | $30,000 |
| Short-term assets | $10,000 |
| Total Current Assets | $175,000 |
| Current Liabilities | |
| Accounts Payable | $80,000 |
| Debt Payments | $5,000 |
| Dividends Declared | $20,000 |
| Taxes | $20,000 |
| Total Current Liabilities | $125,000 |
| Total Current Assets | $175,000 |
| Total Current Liabilities | ($125,000) |
| Working Capital | $50,000 |
Takeaway: Working capital isn’t a static number but shifts as a company spends or receives money and its current asset and liability picture shifts.
How Working Capital Is Used
Working capital is used by companies for the following reasons:
- To better understand how capable they are of meeting their financial obligations or taking advantage of opportunities over the next 12 months.
- To forecast possible future financial distress. If a company’s working capital is negative, it will have to figure out how to access more working capital by using tactics like getting a loan, selling assets, laying off staff, or selling more inventory.
- To compare with other companies: Both management and investors may be interested in knowing how a company's working capital position stack's up against its competitors or against anticipated changes or events relevant to its industry.
Investors should be interested in working capital since it is a measure of a company’s liquidity and short-term financial health. If a company has low working capital, they might be at risk of defaulting on their debt or going bankrupt. If a company has higher than average working capital, it might not be using capital efficiently for growth and might not be a good investment relative to competitors.
Takeaway: Both management and investors can use working capital to determine a company’s short-term health or competitive position.
Bottom Line
Working capital is an important metric to assess whether a business can meet its short-term financial obligations, weather any unforeseen expenditures, and take advantage of short-term opportunities to save money, generate new business, or service existing customers.
