Key Takeaways
- Working capital is crucial for a company’s short-term financial health, reflecting its ability to cover current obligations and operate smoothly.
- It is calculated by subtracting current liabilities from current assets, indicating the amount available for day-to-day operations.
- The working capital ratio provides insight into a company’s ability to meet short-term liabilities, with a ratio above 1 indicating a positive working capital.
- Components of working capital include cash, accounts receivable, inventory, marketable securities, prepaid expenses, accounts payable, and short-term debt.
- Working capital influences cash flow, with changes in working capital affecting cash flow from operating activities.
- Companies can enhance working capital through sales growth, cost reduction, negotiation with suppliers/customers, asset optimization, and accessing short-term financing.
What is Working Capital?
Working capital is a measure of a company’s liquidity, operational efficiency, and short-term financial health. It represents the amount of current assets that a company has available to meet its current liabilities and fund its day-to-day operations. In other words, working capital is the difference between what a company owns and what it owes in the short term.
Working capital is a vital indicator of a company’s financial performance, as it reflects its ability to generate cash, pay its bills, and invest in growth. A positive working capital means that a company has more current assets than current liabilities, which implies that it has enough resources to cover its obligations and fund its operations. A negative working capital means that a company has more current liabilities than current assets, which implies that it may face liquidity problems and struggle to pay its debts and expenses.
Working Capital Formula and Calculation
The most common way to calculate working capital is to subtract current liabilities from current assets. The formula is:
Working Capital=Current Assets−Current Liabilities
Current assets are the assets that a company can easily convert into cash within one year or one operating cycle, whichever is longer. They include cash and cash equivalents, accounts receivable, inventory, marketable securities, prepaid expenses, and other liquid assets.
Current liabilities are the liabilities that a company has to pay within one year or one operating cycle, whichever is longer. They include accounts payable, short-term debt, accrued expenses, taxes payable, and other short-term obligations.
For example, suppose a company has $100,000 in current assets and $80,000 in current liabilities. Its working capital is:
Working Capital=$100,000−$80,000=$20,000
This means that the company has a positive working capital of $20,000, which indicates that it has enough current assets to pay its current liabilities and fund its operations.
Another way to calculate working capital is to use the working capital ratio, which is the ratio of current assets to current liabilities. The formula is:
Working Capital Ratio=Current Assets Current Liabilities
The working capital ratio shows how many times a company can pay its current liabilities with its current assets. A working capital ratio of 1 means that a company has the same amount of current assets and current liabilities. A working capital ratio of more than 1 means that a company has more current assets than current liabilities, which indicates a positive working capital. A working capital ratio of less than 1 means that a company has more current liabilities than current assets, which indicates a negative working capital.
For example, suppose a company has $100,000 in current assets and $80,000 in current liabilities. Its working capital ratio is:
Working Capital Ratio=$100,000$80,000=1.25
This means that the company has a working capital ratio of 1.25, which indicates that it has 1.25 times more current assets than current liabilities, or a positive working capital.
Components of Working Capital
The main components of working capital are:
- Cash and cash equivalents: These are the most liquid assets that a company has, such as cash, bank deposits, money market funds, and treasury bills. They are used to pay for immediate expenses and obligations, as well as to invest in short-term opportunities.
- Accounts receivable: These are the amounts that a company is owed by its customers for the goods or services that it has delivered or performed. They are expected to be collected within a short period of time, usually 30 to 90 days. They are a source of cash inflow for a company, but they also carry the risk of bad debts and delays in payment.
- Inventory: This is the stock of raw materials, work-in-progress, and finished goods that a company has on hand. It is used to meet the demand for its products or services, as well as to take advantage of economies of scale and bulk discounts. It is a source of cash outflow for a company, as it requires storage, maintenance, and insurance costs. It also carries the risk of obsolescence, spoilage, theft, and damage.
- Marketable securities: These are the short-term investments that a company makes in securities that can be easily sold or converted into cash, such as stocks, bonds, and mutual funds. They are used to earn interest or dividends, as well as to diversify the company’s portfolio and reduce its exposure to market fluctuations. They are a source of cash inflow for a company, but they also carry the risk of price volatility and liquidity constraints.
- Prepaid expenses: These are the expenses that a company has paid in advance for goods or services that it will receive or use in the future, such as rent, insurance, taxes, and subscriptions. They are a source of cash outflow for a company, as they reduce its available cash balance. However, they also reduce its future expenses and liabilities, as they have already been paid for.
- Accounts payable: These are the amounts that a company owes to its suppliers, vendors, or creditors for the goods or services that it has received or used. They are expected to be paid within a short period of time, usually 30 to 90 days. They are a source of cash inflow for a company, as they represent a form of short-term financing that allows it to defer its payments. However, they also carry the risk of penalties, interest charges, and loss of creditworthiness if they are not paid on time.
- Short-term debt: This is the debt that a company has to repay within one year or one operating cycle, whichever is longer. It includes bank loans, commercial paper, notes payable, and other borrowings. It is a source of cash inflow for a company, as it provides it with immediate funds to finance its operations or investments. However, it also carries the risk of high interest rates, refinancing difficulties, and default if it is not repaid on time.
- Accrued expenses: These are the expenses that a company has incurred but not yet paid for, such as wages, utilities, interest, and taxes. They are expected to be paid within a short period of time, usually 30 to 90 days. They are a source of cash outflow for a company, as they reduce its net income and cash flow. However, they also reflect its economic activity and performance, as they represent the costs of generating its revenues.
- Taxes payable: These are the taxes that a company has to pay to the government for its income, sales, payroll, or other activities. They are expected to be paid within a short period of time, usually 30 to 90 days. They are a source of cash outflow for a company, as they reduce its net income and cash flow. However, they also reflect its social responsibility and compliance, as they represent its contribution to the public welfare.
Advantages of Working Capital
Some of the advantages of working capital are:
- It enhances liquidity: Working capital enables a company to meet its short-term obligations and expenses, as well as to invest in short-term opportunities. It ensures that a company has enough cash on hand to operate smoothly and efficiently, without facing cash flow problems or liquidity crises.
- It improves profitability: Working capital allows a company to optimize its production, sales, and inventory levels, as well as to take advantage of discounts, rebates, and incentives. It helps a company to reduce its costs, increase its revenues, and maximize its margins and returns.
- It boosts solvency: Working capital strengthens a company’s balance sheet and credit profile, as it shows that it has more assets than liabilities, and that it can generate more cash than it consumes. It enhances a company’s ability to repay its debts and obligations, as well as to access more financing options and better terms and conditions.
- It supports growth: Working capital facilitates a company’s expansion and diversification, as it provides it with the resources and flexibility to pursue new markets, products, or services, as well as to acquire new assets, equipment, or technology. It enables a company to seize new opportunities and gain a competitive edge.
Limitations of Working Capital
Some of the limitations of working capital are:
- It requires trade-offs: Working capital involves a trade-off between liquidity and profitability, as well as between risk and return. A company that has too much working capital may have excess cash that is idle or invested in low-return assets, which reduces its profitability and efficiency. A company that has too little working capital may have insufficient cash to meet its obligations and expenses, which increases its risk and vulnerability.
- It depends on external factors: Working capital is influenced by various external factors that are beyond a company’s control, such as market conditions, customer behavior, supplier relations, competitor actions, and regulatory changes. These factors can affect a company’s cash inflows and outflows, as well as its working capital needs and availability. A company may face unexpected fluctuations or shortages in its working capital, which can disrupt its operations and performance.
- It involves opportunity costs: Working capital represents the opportunity cost of using current assets to fund current liabilities, rather than investing them in long-term assets or projects. A company that has to allocate a large portion of its current assets to working capital may have less funds available for capital expenditures, research and development, or acquisitions, which can limit its growth potential and competitive advantage.
Working Capital vs. Net Working Capital
Working capital and net working capital are two related but distinct concepts that measure a company’s liquidity, operational efficiency, and short-term financial health. The main difference between them is that working capital is the difference between current assets and current liabilities, while net working capital is the difference between current assets and non-interest-bearing current liabilities.
Non-interest-bearing current liabilities are the current liabilities that do not incur interest charges, such as accounts payable, taxes payable, and accrued expenses. Interest-bearing current liabilities are the current liabilities that do incur interest charges, such as short-term debt, commercial paper, notes payable, and other borrowings.
The reason why net working capital excludes interest-bearing current liabilities is that they represent a form of financing that a company can use to increase its working capital availability and enhance its return on equity. By using interest-bearing current liabilities, a company can leverage its current assets and generate more cash than it consumes. However, this also increases its risk and cost of capital, as it has to pay interest and repay the principal on time.
The formula for net working capital is:
Net Working Capital=Current Assets−Non-Interest-Bearing Current Liabilities
For example, suppose a company has $100,000 in current assets, $50,000 in non-interest-bearing current liabilities, and $30,000 in interest-bearing current liabilities. Its working capital and net working capital are:
Working Capital=$100,000−($50,000+$30,000)=$20,000
Net Working Capital=$100,000−$50,000=$50,000
This means that the company has a positive working capital of $20,000, which indicates that it has enough current assets to pay its current liabilities and fund its operations. However, it also has a higher net working capital of $50,000, which indicates that it has more current assets to pay its non-interest-bearing current liabilities and invest in growth.
Working Capital vs. Fixed Assets/Capital
Working capital and fixed assets/capital are two different types of assets that a company uses to run its business and generate value. The main difference between them is that working capital is the current assets that a company uses to fund its current liabilities and operations, while fixed assets/capital are the long-term assets that a company uses to produce its goods or services and create its competitive advantage.
Fixed assets/capital are the assets that a company cannot easily convert into cash within one year or one operating cycle, whichever is longer. They include land, buildings, machinery, equipment, vehicles, furniture, and other tangible or intangible assets that have a useful life of more than one year. They are used to support the company’s core business activities and generate its long-term revenues and profits.
The formula for fixed assets/capital is:
Fixed Assets/Capital=Total Assets−Current Assets
For example, suppose a company has $200,000 in total assets, $100,000 in current assets, and $80,000 in current liabilities. Its working capital and fixed assets/capital are:
Working Capital=$100,000−$80,000=$20,000
Fixed Assets/Capital=$200,000−$100,000=$100,000
This means that the company has a positive working capital of $20,000, which indicates that it has enough current assets to pay its current liabilities and fund its operations. However, it also has a higher fixed assets/capital of $100,000, which indicates that it has more long-term assets to produce its goods or services and create its competitive advantage.
Working Capital and the Balance Sheet
The balance sheet is one of the main financial statements that a company prepares and reports to show its financial position and performance. It summarizes the company’s assets, liabilities, and equity at a specific point in time, usually at the end of a fiscal year or quarter.
The balance sheet follows the accounting equation, which is:
Assets=Liabilities + Equity
This means that the total value of the company’s assets must equal the total value of its liabilities and equity, or the sources of funds that it uses to acquire its assets.
The balance sheet is divided into two sections: the current section and the non-current section. The current section lists the current assets and current liabilities, which are the assets and liabilities that are expected to be realized or settled within one year or one operating cycle, whichever is longer. The non-current section lists the non-current assets and non-current liabilities, which are the assets and liabilities that are expected to be realised or settled beyond one year or one operating cycle, whichever is longer.
The balance sheet also shows the working capital and the net working capital of the company, which are calculated as follows:
Working Capital=Current Assets−Current Liabilities
Net Working Capital=Current Assets−Non-Interest-Bearing Current Liabilities
The working capital and the net working capital reflect the company’s liquidity, operational efficiency, and short-term financial health, as they measure the amount of current assets that the company has available to meet its current liabilities and fund its operations.
How Working Capital Affects Cash Flow
Cash flow is another important financial statement that a company prepares and reports to show its cash inflows and outflows during a specific period, usually a fiscal year or quarter. It summarizes the company’s cash receipts and payments from its operating, investing, and financing activities, as well as the net increase or decrease in its cash and cash equivalents.
Cash flow follows the cash flow equation, which is:
Cash Flow=Cash Flow from Operating Activities + Cash Flow from Investing Activities + Cash Flow from Financing Activities
This means that the net change in the company’s cash and cash equivalents during a period is equal to the sum of its cash flows from its operating, investing, and financing activities.
The cash flow statement is divided into three sections: the operating section, the investing section, and the financing section. The operating section lists the cash flows from the company’s core business activities, such as selling goods or services, paying for expenses, or collecting revenues. The investing section lists the cash flows from the company’s capital expenditures, such as buying or selling fixed assets, or making or receiving loans. The financing section lists the cash flows from the company’s funding sources, such as issuing or repaying debt, or issuing or repurchasing equity.
The cash flow statement also shows the change in the company’s working capital, which is calculated as follows:
Change in Working Capital=Working Capital at the End of the Period−Working Capital at the Beginning of the Period
The change in the company’s working capital affects its cash flow from operating activities, as it represents the net effect of the changes in its current assets and current liabilities on its cash flow. A positive change in working capital means that the company has increased its current assets or decreased its current liabilities, which implies that it has used more cash than it has generated from its operations. A negative change in working capital means that the company has decreased its current assets or increased its current liabilities, which implies that it has generated more cash than it has used from its operations.
What is Working Capital Management?
Working capital management is the process of managing the balance between a company’s current assets and current liabilities, to optimize its liquidity, profitability, and operational efficiency. Working capital management involves making decisions about how much cash to keep on hand, how much inventory to hold, how to collect payments from customers, how to pay suppliers, and how to finance short-term needs.
Working capital management is a trade-off between risk and return. On one hand, having more working capital means having more cash available to invest in growth opportunities, take advantage of discounts, and cope with unexpected expenses. On the other hand, having too much working capital means having idle cash that could be earning a higher return elsewhere, or having excess inventory that could become obsolete or spoil.
Similarly, having less working capital means having less cash tied up in current assets, which could improve the return on assets and reduce the cost of capital. However, having too little working capital means having insufficient cash to meet current obligations, which could lead to late payments, penalties, or even bankruptcy.
Therefore, working capital management requires finding the optimal level of working capital that maximizes the value of the company, while minimizing the risk of insolvency.
Why is Working Capital Important?
- Working capital is important for several reasons. First, working capital reflects the liquidity and solvency of a company, or its ability to pay its bills and debts on time. A positive working capital means that a company has more current assets than current liabilities, which indicates that it has enough cash to cover its short-term needs. Negative working capital means that a company has more current liabilities than current assets, which indicates that it may face cash flow problems or default on its obligations.
- Working capital affects the profitability and efficiency of a company, or its ability to generate income and reduce costs. A high working capital means that a company has a lot of cash or inventory that is not being used effectively, which could lower its return on assets and increase its cost of capital. A low working capital means that a company has a tight cash flow or inventory that is being used efficiently, which could increase its return on assets and reduce its cost of capital.
- Working capital influences the growth and competitiveness of a company, or its ability to seize opportunities and gain market share. A sufficient working capital means that a company has enough cash to invest in new projects, expand its operations, or acquire new customers. A insufficient working capital means that a company has limited cash to invest in new projects, expand its operations, or acquire new customers.
Example of Working Capital
To illustrate how working capital works, let us look at an example of a hypothetical company called ABC Inc. ABC Inc. is a retailer that sells clothing and accessories. The following table shows the current assets and current liabilities of ABC Inc. as of December 31, 2023.
| Current Assets | Amount ($) |
| Cash | 50,000 |
| Accounts Receivable | 40,000 |
| Inventory | 60,000 |
| Marketable Securities | 10,000 |
| Total Current Assets | 160,000 |
| Current Liabilities | Amount ($) |
| Accounts Payable | 30,000 |
| Short-term Loans | 20,000 |
| Accrued Expenses | 10,000 |
| Taxes Payable | 15,000 |
| Total Current Liabilities | 75,000 |
Using the working capital formula, we can calculate the working capital of ABC Inc. as follows:
Working Capital=Current Assets−Current Liabilities
Working Capital=160,000−75,000
Working Capital=85,000
This means that ABC Inc. has a positive working capital of $85,000, which indicates that it has enough cash to meet its short-term obligations and fund its day-to-day operations.
Using the working capital ratio formula, we can calculate the working capital ratio of ABC Inc. as follows:
Working Capital Ratio=Current Assets/Current Liabilities
Working Capital Ratio=160,000/75,000
Working Capital Ratio=2.13
This means that ABC Inc. has a working capital ratio of 2.13, which indicates that it has 2.13 times more current assets than current liabilities.
How Can a Company Improve Its Working Capital?
There are several ways that a company can improve its working capital, depending on whether it wants to increase its current assets, decrease its current liabilities, or both. Some of the common methods are:
- Increasing sales and revenue: This can increase the cash inflow and the accounts receivable of a company, which can boost its current assets and working capital. However, this may also increase the inventory and the accounts payable of a company, which can reduce its working capital. Therefore, a company should aim to increase its sales and revenue while maintaining a low inventory turnover and a high accounts receivable turnover.
- Reducing costs and expenses: This can decrease the cash outflow and the accrued expenses of a company, which can lower its current liabilities and increase its working capital. However, this may also decrease the quality and quantity of the products or services of a company, which can affect its sales and revenue. Therefore, a company should aim to reduce its costs and expenses while maintaining a high customer satisfaction and loyalty.
- Negotiating better terms with suppliers and customers: This can improve the cash conversion cycle and the working capital cycle of a company, which can enhance its working capital. For example, a company can negotiate longer payment terms with its suppliers, which can increase its accounts payable and reduce its cash outflow. Alternatively, a company can negotiate shorter payment terms with its customers, which can decrease its accounts receivable and increase its cash inflow.
- Selling or leasing unused assets: This can generate cash from the disposal or rental of idle or obsolete assets, such as equipment, machinery, or property, which can increase the current assets and working capital of a company. However, this may also reduce the productive capacity and the future earnings potential of a company. Therefore, a company should carefully evaluate the benefits and costs of selling or leasing its unused assets.
- Obtaining short-term financing: This can provide additional cash to meet the working capital needs of a company, such as a bank overdraft, a line of credit, or a trade credit. However, this may also increase the interest expense and the debt burden of a company, which can lower its profitability and solvency. Therefore, a company should use short-term financing only as a last resort and repay it as soon as possible.
Applications of Working Capital
Working capital is a useful concept that can be applied in various scenarios, such as:
- Budgeting and forecasting: Working capital can help a company plan and project its cash flow and financial performance for the future, by estimating its current assets and current liabilities based on its historical data and expected growth. This can help a company set realistic and achievable goals, allocate resources efficiently, and monitor and control its progress.
- Valuation and investment: Working capital can help a company assess its value and attractiveness to potential investors, by measuring its liquidity, profitability, and efficiency. A positive and high working capital indicates that a company has a strong financial position and a competitive edge, which can increase its market value and attract more investors. A negative and low working capital indicates that a company has a weak financial position and a competitive disadvantage, which can decrease its market value and deter investors.
- Benchmarking and comparison: Working capital can help a company compare its performance and position with its peers and competitors, by using common ratios and metrics, such as the working capital ratio, the net working capital, the working capital turnover, and the cash conversion cycle. These ratios and metrics can reveal the strengths and weaknesses of a company, as well as the opportunities and threats in the industry.
- Risk management and contingency planning: Working capital can help a company identify and mitigate the risks and uncertainties that may affect its cash flow and operations, by providing a buffer and a cushion to cope with unexpected events, such as demand fluctuations, supply disruptions, price changes, or economic downturns. Working capital can also help a company prepare and implement contingency plans, such as securing alternative sources of financing, reducing inventory levels, or diversifying revenue streams.
How Knowcraft Analytics Improves Businesses’ Working Capital?
Knowcraft Analytics is a company that provides accounting, taxation, and valuation services to financial service firms in the US and Canada. One of the ways that Knowcraft Analytics improves businesses working capital is by helping them optimize their cash conversion cycle and working capital cycle. These cycles measure how efficiently a business converts its current assets and current liabilities into cash. By using data analytics and best practices, Knowcraft Analytics can help businesses reduce their inventory, accounts receivable, and accounts payable, and increase their cash inflow and outflow. This can enhance their liquidity, profitability, and operational efficiency.
FAQs of Working Capital
Here are some frequently asked questions and answers about working capital:
1. What is a good working capital ratio?
There is no definitive answer to what a good working capital ratio is, as it may vary depending on the industry, the business model, and the economic conditions. However, a general rule of thumb is that a working capital ratio between 1.2 and 2.0 is considered healthy and adequate, as it indicates that a company has enough current assets to cover its current liabilities, without having too much idle cash or inventory. A working capital ratio below 1.0 is considered risky and insufficient, as it indicates that a company may not have enough current assets to cover its current liabilities and may face liquidity problems or insolvency. A working capital ratio above 2.0 is considered excessive and inefficient, as it indicates that a company may have too much current assets that are not being used effectively and may lower its return on assets and increase its cost of capital.
2. What is net working capital?
Net working capital is another way of expressing working capital, by subtracting the current liabilities from the current assets. Net working capital shows the net amount of money that a company has available to meet its short-term obligations and fund its day-to-day operations. A positive net working capital means that a company has more current assets than current liabilities, which indicates that it has a surplus of cash. A negative net working capital means that a company has more current liabilities than current assets, which indicates that it has a deficit of cash.
3. What is change in net working capital?
Change in net working capital is the difference between the net working capital at the end of a period and the net working capital at the beginning of a period. Change in net working capital shows how much the working capital of a company has increased or decreased over a period. A positive change in net working capital means that the net working capital of a company has increased, which indicates that it has generated more cash from its operations. A negative change in net working capital means that the net working capital of a company has decreased, which indicates that it has used more cash for its operations.
4. What is working capital management?
Working capital management is the process of managing the balance between a company’s current assets and current liabilities, to optimize its liquidity, profitability, and operational efficiency. Working capital management involves making decisions about how much cash to keep on hand, how much inventory to hold, how to collect payments from customers, how to pay suppliers, and how to finance short-term needs. Working capital management is a trade-off between risk and return, as having working capital can have positive or negative effects on a company’s value and performance.
5. How can a company improve its working capital?
There are several ways that a company can improve its working capital, depending on whether it wants to increase its current assets, decrease its current liabilities, or both. Some of the common methods are increasing sales and revenue, reducing costs and expenses, negotiating better terms with suppliers and customers, selling or leasing unused assets, and obtaining short-term financing. These methods can help a company increase its cash inflow, decrease its cash outflow, or both, which can enhance its working capital.
