Working capital refers to the difference between a company’s current assets, such as cash, accounts receivable, and inventories, and its current liabilities, like accounts payable and short-term debts. It is the amount of money readily available to meet the daily operational expenses of the business.
In simpler terms, it shows how well a company can pay its bills and manage its financial operations with its current assets and liabilities. Essentially, it is the amount of money left over after a company has paid its current liabilities.
How to Calculate Working Capital
A simple formula is used for calculating working capital:
Working Capital = Current Assets – Current Liabilities
- Current assets refer to items that can be quickly converted into cash such as accounts receivable, inventory, and cash equivalents.
- Current liabilities are obligations that are due within one year such as accounts payable, taxes, salaries, and short-term loans.
Examples of Working Capital
Here are a few examples of calculating working capital:
- If a company has current assets worth $500,000 and current liabilities worth $150,000, then the working capital is $350,000.
- If a company has current assets worth $1,000,000 and current liabilities worth $1,200,000, then the working capital is -$200,000 (negative working capital).
- If a company has current assets worth $800,000 and current liabilities worth $600,000, then the working capital is $200,000.
Components of Working Capital
Working capital is made up of several components, including:
- Cash: The amount of money a company has on hand to pay its bills.
- Accounts receivable: The amount of money owed to a company by its customers for goods or services that have been delivered but not yet paid for.
- Inventory: The value of a company’s products that have not yet been sold.
- Accounts payable: The amount of money a company owes to its suppliers for goods or services that have been delivered but not yet paid for.
- Short-term loans: The amount of money a company has borrowed from lenders to cover its short-term obligations.
Working Capital FAQ
Here are some frequently asked questions on working capital:
Why Is Working Capital Important?
Working capital is important because it measures a company’s ability to cover its debts in the short term. Without adequate working capital, a business may struggle to pay its bills and maintain operations.
What Is a Healthy Working Capital?
In general, a healthy working capital means a positive figure or a current asset factor of two or more. A high working capital ratio signals that a company is in a better position to pay off its short-term debt.
What Happens if Working Capital Is Negative?
A negative working capital implies that a company is using its cash or short-term assets to fund its operations. This can indicate that the company is struggling with its finances, faced with unexpectedly low sales or is financing growth with debt or equity. Negative working capital is a red flag for investors and lenders.
How Can a Business Improve its Working Capital?
A business can improve its working capital by increasing inflows (sales), freeing up cash from its inventory or accounts receivables, or reducing outflows (managing expenses) and avoiding unnecessary costs.