Working capital is an accounting term that refers to a company’s available capital for daily operations at any given point in time. It is defined as the difference between a company’s current assets and current liabilities. In order to operate effectively, a company should have more assets than liabilities to ensure that it has enough assets to pay its short-term debt. The amount of working capital a company has is a good measure of its liquidity, efficiency and financial health.
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Working Capital Terms
The first place to start in analyzing a company’s finances is its accounting balance sheets. Balance sheets provide a company's financial position at a particular point in time (generally at the end of a quarter or year). Balance sheets lay out the ending balances of a company’s assets, liabilities and equity. This is where the information necessary to calculate a company’s working capital is found.
A company’s assets are any items of economic value that a company owns or controls. Assets can provide immediate or future benefits. It can also include costs paid in advance (e.g., prepaid insurance, prepaid rent, etc.). Examples of assets are cash, accounts receivables, inventory, supplies, land, buildings and equipment. Assets are considered current assets when they are expected to be liquidated into cash or be used within one year.
A company’s liabilities are any financial debt or obligations that a company is responsible for due to its business operations. Liabilities often include "payable" in their account title on the balance sheet. Examples of liabilities are notes payable, accounts payable, salaries payable, wages payable and income taxes payable. Liabilities are considered current liabilities if the debts or obligations are due within one year.
How to Calculate Working Capital
As mentioned above, working capital deals with a company’s current assets and current liabilities only. Since working capital is only concerned with assets utilized and liabilities due within one year, working capital does not factor in long-term assets or long-term liabilities. To calculate working capital, a company would deduct the value of its current liabilities from its current assets.
Working Capital = Current Assets – Current Liabilities
In addition to calculating a company’s working capital, determining a company’s working capital ratio, also referred to as the current ratio, is also useful. Working capital ratio portrays a company’s ability to pay for its current liabilities with its currents assets. The ratio is calculated by dividing current assets by current liabilities. A current ratio below 1 indicates negative working capital, while a ratio above 2 indicates that a company is not investing excess assets. The ideal range is a ratio between 1 and 2.
Working Capital Ratio (Current Ratio) = Current Assets ÷ Current Liabilities
Let’s take a look at a hypothetical company’s (Company ABC) current assets and liabilities:
|Accounts Receivable||$170,000||Salaries Payable||$120,000|
|Total Current Assets||$500,000||Total Current Liabilities||$350,000|
Company ABC has current assets of $500,000 and current liabilities of $350,000. In this example, the company’s working capital would be $150,000 ($500,000 – $350,000) and its working capital ratio would be 1.4 ($500,000 ÷$350,000). Company ABC would be considered to be in good financial health.
What Does Working Capital Tell You
A company with negative working capital (more liabilities than assets) is generally seen as being in financial risk for increased debt (which may lead to bankruptcy). If a company has negative working capital, it may have trouble paying back its short-term debt. In this scenario, a company may turn to traditional financing options to bolster its working capital such as loans, lines of credit or cash advances. In addition, a company may also raise capital through the selling of equity, selling of invoices (invoice factoring) or arranging inventory advances (trade credit).
While negative working capital is generally viewed negatively, there have been scenarios where companies operate on business models that strategically value negative working capital. Companies such as Dell, Amazon and Walmart all operate successfully with negative working capital. These companies succeed by selling their products to consumers before actually paying for them. When a company outsources its assets to suppliers, it essentially shifts its inventory from its books to its suppliers’ books. In this situation, the company’s assets would be a lower amount than normal and would lead to a negative working capital despite running efficiently.
A company with positive working capital (more assets than liabilities) is seen as being in good short-term financial health. Even with a significant amount of positive working capital, however, a company can experience a cash shortage if its current assets are unable to be liquidated quickly. The amount of time it takes to turn current assets and current liabilities into cash is referred to as the working capital cycle.
The shorter the working capital cycle, the more effective a company’s working capital is. The longer the working capital cycle, the more time a company’s capital is tied up without earning returns. As such, companies strive to reduce their working capital cycle by collecting their receivables quicker and deferring their payables longer. Companies should also monitor their working capital ratio and ensure that they are investing excess assets whenever possible.