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Working capital is an accounting term that refers to a company’s available capital for daily operations at any given point in time. The working capital formula is:
Net working capital = current assets - current liabilities
Understanding your business's working capital will come in handy when applying for equity or debt financing, working with partners and more. Many refer to working capital as the ability to pay off debt within a year.
Examples of Calculating Net Working Capital
Let's calculate the net working capital of a fictional manufacturer. It has the following financials:
- Outstanding Accounts Receivable: $50,000
- Cash: $10,000
- Inventory: $200,000
- Accrued Expenses: $20,000
- Outstanding Accounts Payable: $30,000
Net Working Capital = ($50,000 + $10,000 + $200,000) - ($20,000 + $30,000) = $210,000
Since this fictional business's assets exceed its liabilities, its working capital is positive. Because the business can pay off its debt very quickly using its immediate assets, it is considered liquid. To a certain extent, the more liquid a business is, the better.
Another commonly used working capital formula is the working capital ratio. Working capital ratio is equal to total assets / total liabilities.
Working capital ratio = ($50,000 + $10,000 + $200,000) / ($20,000 + $30,000) = 5.2
This may seem like a positive ratio since it has much more assets than liabilities, but a ratio that's too high may be seen as a negative. We dive into this below.
What's Included in Working Capital?
At the highest level, working capital is divided into two parts: Assets and liabilities.
A company’s assets are any items of economic value that a company owns or controls. Assets can provide immediate or future benefits. Assets can also include costs paid in advance (e.g., prepaid insurance, prepaid rent, etc.). Examples of assets are cash, accounts receivable, 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.
What's a Good Level of Working Capital?
Lenders, creditors and partners will all assess working capital to get a sense of business's health. If a business has either negative net working capital or a working capital ratio below 1.0, the business either has notable liquidity issues or isn't productive enough compared to how much debt its taking on. Whatever the case is, it's a serious red flag.
Ideally, you'd like to have positive net working capital and a working capital ratio between 1.2 and 2.0. This likely represents a healthy business that has enough short-term or current assets to fully secure its immediate debt.
On the other end, a working capital ratio greater than 2.0 can be problematic. While it may not be as serious of an issue as a business with negative net working capital or a ratio below 1.0, it could mean that the business isn't operating at a proper efficiency level. If a business has too many current assets, it could be an indication of a bloated business.
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.