What is Working Capital? (2024)

Finance teams that want to know whether their companies can withstand an unexpected downturnor crisis need a handle on two metrics: working capital and cash flow. These two metricsillustrate different aspects of a company’s financial health.

While cash flow measures how much money the company generates or consumes in a given period,working capital is the difference between the company’s current assets —including cash and other assets that can be converted into cash within a year — andits current liabilities, such as payroll, accounts payable and accrued expenses.

A business that maintains positive working capital will likely have a greater ability towithstand financial challenges and the flexibility to invest in growth after meetingshort-term obligations.

What Is Working Capital?

Working capital is calculated by subtracting current liabilities from current assets, aslisted on the company’s balance sheet. Current assets include cash,accounts receivable and inventory. Current liabilities include accounts payable, taxes,wages and interest owed.

Key Takeaways

• Working capital is a financial metric calculated as the difference between currentassets and current liabilities.
• Positive working capital means the company can pay its bills and invest to spur businessgrowth.
• Working capital management focuses on ensuring the company can meet day-to-day operatingexpenses while using its financial resources in the most productive and efficient way.

Working Capital Explained

Working capital is a financial metric that is the difference between a company's curentassets and current liabilities. As a financial metric, working capital helps plan for futureneeds and ensure the company has enough cash and cash equivalents meet short-termobligations, such as unpaid taxes and short-term debt.

Example: A manufacturer has assets totaling $220,000 andliabilities totalling $130,000.

Why Is Working Capital Important?

Working capital is used to fund operations and meet short-term obligations. If a company hasenough working capital, it can continue to pay its employees and suppliers and meet otherobligations, such as interest payments and taxes, even if it runs into cash flowchallenges.

Working capital can also be used to fund business growth without incurring debt. If thecompany does need to borrow money, demonstrating positive working capital can make it easierto qualify for loans or other forms of credit.

For finance teams, the goal is twofold: Have a clear view of how much cash is on hand at anygiven time, and work with the business to maintain sufficient working capital to coverliabilities, plus some leeway for growth and contingencies.

Advantages of Working Capital

Working capital can help smooth out fluctuations in revenue. Many businesses experience someseasonality in sales, selling more during some months than others, for example. Withadequate working capital, a company can make extra purchases from suppliers to prepare forbusy months while meeting its financial obligations during periods where it generates lessrevenue.

For example, a retailer may generate 70% of its revenue in November and December — butit needs to cover expenses, such as rent and payroll, all year. By analyzing its workingcapital needs and maintaining an adequate buffer, the retailer can ensure it hasenough funds to stock up on supplies before November and hire temps for the busyseason whileplanning how many permanent staff it can support.

Working Capital and the Balance Sheet

Working capital is calculated from current assets and currentliabilities reported on a company’s balance sheet. A balance sheet is one of the threeprimary financial statements that businesses produce; the other two are the income statementand cash flow statement.

The balance sheet is a snapshot of the company’s assets, liabilities andshareholders’ equity at a moment in time, such as the end of a quarter or fiscal year.The balance sheet includes all of a company’s assets and liabilities, both short- andlong-term.

The balance sheet lists assets by category in order of liquidity, starting with cash and cashequivalents. It also lists liabilities by category, with current liabilities first followedby long-term liabilities.

How to Calculate Working Capital

Working capital is calculated as current assets minus current liabilities, as detailed on thebalance sheet.

Formula for Working Capital

Working capital = current assets - currentliabilities

Positive vs. Negative Working Capital

A company has positive working capital if it has enough cash, accounts receivable andother liquid assets to cover its short-term obligations, such as accounts payable and short-term debt.

In contrast, a company has negative working capital if it doesn’t have enough currentassets to cover its short-term financial obligations. A company with negative workingcapital may have trouble paying suppliers and creditors and difficulty raising funds todrive business growth. If the situation continues, it may eventually be forced to shut down.

Elements Included in Working Capital

The current assets and liabilities used to calculate working capital typically include thefollowing items:

Current assets

include cash and other liquid assets that can be converted into cash withinone year of the balance sheet date, including:

• Cash, including money in bank accounts and undeposited checks from customers.
• Marketable securities, such as U.S. Treasury bills and money market funds.
• Short-term investments a company intends to sell within one year.
• Accounts receivable, minus any allowances for accounts that are unlikely to be paid.
• Notes receivable — such as short-term loans to customers or suppliers —maturing within one year.
• Other receivables, such as income tax refunds, cash advances to employees and insuranceclaims.
• Inventory including raw materials, work in process and finished goods.
• Prepaid expenses,such as insurance premiums.
• Advance payments on future purchases.

Current liabilities

are all liabilities due within a year of the balance sheet date, including:

• Accounts payable.
• Notes payable due within one year.
• Wages payable.
• Taxes payable.
• Interest payable on loans.
• Any loan principal that must be paid within a year.
• Other accrued expenses payable.
• Deferred revenue, such as advance payments from customers for goods or services not yetdelivered.

Working Capital Example

The following working capital example is based on the March 31, 2020, balance sheet ofaluminum producer Alcoa Corp., as listed in its 10-Q SEC filing. All amounts are inmillions.

Alcoa listed current assets of $3,333 million, and current liabilities of $2,223 million. Itsworking capital was therefore $3,333 million - $2,223 million = $1,110 million. Thatrepresented an increase of $143 million compared with three months earlier, on Dec. 31,2019, when the company had $967 million in working capital.

How Working Capital Affects Cash Flow

Cash flow is the amount of cash and cash equivalents that moves in and out of the businessduring an accounting period. Cash flow is summarized in the company’s cash flow statement.

A company’s cash flow affects its amount of working capital. If revenue declines andthe company experiences negative cash flow as a result, it will draw down its workingcapital. Investing in increased production may also result in a decrease in working capital.

Working Capital vs. Net Working Capital

The terms “working capital” and “net working capital” are synonymous:Both refer to the difference between all current assets and all current liabilities.

However, some analysts define net working capital more narrowly than working capital.

One of these alternative formulas excludes cash and debt:

Net working capital = current assets (lesscash) - current liabilities (less debt)

An even narrower definition excludes most types of asset, focusing only on accountsreceivable, accounts payable and inventory:

Net working capital = accounts receivable +inventory - accounts payable

Working Capital vs. Fixed Assets/Capital

Working capital includes only current assets, which have a high degree of liquidity —they can be converted into cash relatively quickly. Fixed assetsare not included in working capital because they are illiquid; that is, they cannot beeasily converted to cash.

Fixed assets include real estate, facilities, equipment and other tangible assets, as well asintangible assets like patents and trademarks.

What Is Working Capital Management?

Working capital management is a financial strategy that involves optimizing the use ofworking capital to meet day-to-day operating expenses while helping ensure the companyinvests its resources in productive ways. Effective working capital management enables thebusiness to fund the cost of operations and pay short-term debt.

Several financial ratios are commonly used in working capital management to assess thecompany’s working capital and related factors.

The working capital ratio, also known as the current ratio,is a measure of the company’s ability to meet short-term obligations. It’scalculated as current assets divided by current liabilities.

A working capital ratio of less than one means a company isn’t generating enough cashto pay down the debts due in the coming year. Working capital ratios between 1.2 and 2.0indicate a company is making effective use of its assets. Ratios greater than 2.0 indicatethe company may not be making the best use of its assets; it is maintaining a large amountof short-term assets instead of reinvesting the funds to generate revenue.

The average collection period measures how efficiently a company managesaccounts receivable, which directly affects its working capital. The ratio represents theaverage number of days it takes to receive payment after a sale on credit. It’scalculated by dividing the average total accounts receivable during a period by the totalnet credit sales and multiplying the result by the number of days in the period.

The inventory turnover ratio is an indicator of how efficiently a companymanages inventory to meet demand. Tracking this number helps companies ensure they have enough inventory onhand while avoiding tying up too much cash in inventory that sits unsold.

The inventory turnover ratio indicates how many times inventory is sold and replenishedduring a specific period. It’s calculated as cost of goods sold (COGS) divided by theaverage value of inventory during the period. A higher ratio indicates inventory turns overmore frequently.

Working Capital: The Quick Ratio and Current Ratio

Analysts and lenders use the current ratio (working capital ratio) as well as a relatedmetric, the quick ratio, to measure a company’s liquidity and ability to meet itsshort-term obligations.

These two ratios are also used to compare a business’s current performance with priorquarters and to compare the business with other companies, making it useful for lenders andinvestors.

Quick Ratio

The quick ratio differs from the current ratio by including only the company’s mostliquid assets — the assets that it can quickly turn into cash. These are cash andequivalents, marketable securities and accounts receivable.

Curent Ratio

In contrast, the current ratio includes all current assets, including assets that may not beeasy to convert into cash, such as inventory.

Because of this, the quick ratio can be a better indicator of the company’s ability toraise cash quickly when needed.

Does Working Capital Change?

For most companies, working capital constantly fluctuates; the balance sheet captures asnapshot of its value on a specific date. Many factors can influence the amount of workingcapital, including big outgoing payments and seasonal fluctuations in sales.

6 Ways to Increase Working Capital

A business may wish to increase its working capital if it, for example, needs to coverproject-related expenses or experiences a temporary drop in sales. Tactics to bridge thatgap involve either adding to current assets or reducing current liabilities.

Options include:

1. Taking on long-term debt. This increases current assets by adding to the company’savailable cash but doesn’t overly increase current liabilities.
2. Refinancing short-term debt as longer-term debt. This reduces current liabilitiesbecause the debts are no longer due within a year.
3. Selling illiquid assets for cash, thus increasing current assets.
4. Analyzing and reducing expenses, reducing current liabilities.
5. Analyze and optimize inventory management to reduce overstocking and the likelihood thatinventory will need to be written off.
6. Automate accounts receivable and payment monitoring. This can increase cash flow,reducing the need to draw on working capital for day-to-day operations.

Managing working capitalwith accounting software is important for your company’s health. Positiveworking capital means you have enough liquid assets to invest in growth while meetingshort-term obligations, like paying suppliers and making interest payments on loans.

In contrast, negative working capital is a warning sign that a company may have difficultykeeping its head above water — and an ERP with strong compliancemanagement improves business performance and increases financial close efficiency whilereducing back-office costs, resolving delays and generating statements and disclosures thatcomply with regulatory requirements.