What Is Working Capital and How to Calculate It (With Tips)
By Indeed Editorial Team
Published June 17, 2022
The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.
Working capital refers to a company's immediate liquid assets and is an important metric for investors. It's typically a reliable indicator of a company's ability to manage its resources effectively. Understanding what working capital is and how to calculate it can help you make informed financial, investment, and business management decisions. In this article, we explain what working capital is, discuss evaluating and managing a company's working capital, describe how to calculate it, and share an example to consider.
What is working capital?
If you're working in accounting, investing, or business management for a company, you might wonder, "What is working capital?" Working capital is a company's level of liquidity or operational efficiency at a given time. While working capital is not a guarantee of a company's financial health, it can help financial professionals determine a company's ability to pay its current or short-term debts. Maintaining a positive working capital is important for ensuring a company can both reasonably continue operations and satisfy its short-term debts.
Financial analysts calculate working capital by subtracting a company's current liabilities from current assets. This value can provide business managers with important information about a business, such as its ability to foresee and plan for any potential problems without going further into debt. Companies typically have enough working capital to pay their bills for a year. If a company has substantial positive net working capital, investors may view this as an opportunity for further growth and investment. If a company has a negative value, it may not have the ability to pay back creditors, sometimes resulting in bankruptcy.
Evaluating a company's working capital
Working capital can predict a company's future creditworthiness. Creditors may consider companies without enough working capital as a higher risk for loans or lines of credit. This can make it difficult for a company to finance assets or borrow money. Further, a public company's negative working capital may cause stock prices to fall if investors don't feel confident in the company's financial standing. Results can be even more detrimental for smaller businesses or start-ups. Insufficient working capital may cause an entire operation to cease, as many rely on working capital to stay operational until the business earns a profit.
Conversely, an excess of working capital may not always be positive. This might indicate that a business has too much inventory or is mismanaging its cash. Some investors believe a high working capital shows a business may not be investing in long-term growth. For example, companies with high inventory turnover, such as grocery stores that replenish products daily, might see a high net working capital. In these cases, this high value may indicate the business isn't investing enough in new equipment, training, or modernization to maintain competitiveness.
Methods of managing working capital
Companies can manage working capital by keeping optimal balances of assets and liabilities. Here are some approaches to managing working capital that financial managers may use:
Evaluating the balance sheet can provide opportunities for either increasing assets or reducing liabilities to enhance a company's working capital. Reviewing a company's past balance sheets can help financial managers to determine the minimum amount of cash needed to meet daily operational costs. It may also be effective to reduce unnecessary expenses through expense reduction or cost-cutting. Some organizations may consider negotiating with vendors to secure discounts or arrange better prices with suppliers.
Financial managers may explore options for a more attractive credit policy or altered terms for the company and its customers. An agreeable credit policy can attract more new customers and increase cash flow. Further, for businesses that extend credit, it may be beneficial to review any uncollectable receivables or bad credit. These businesses may reduce their bad debt by selling more higher-margin products or adjusting the margins of their current offerings.
Finding sources of financing that are a better fit for the company's specific needs and have better interest rates can help businesses increase working capital. Companies may work with their bank to lengthen the terms of repayment or adjust other unique facets of their financing to help manage working capital. Financial managers might also refrain from financing fixed assets with working capital, or assets used to generate long-term growth, such as plant, property, and equipment assets. It may be beneficial for companies to finance these larger purchases with long-term loans or leasing.
Businesses can increase working capital by identifying the ideal levels of inventory to reduce the amount of unsold inventory in holding. They might also find success in evaluating the timing of raw material deliveries to decrease the cost of these materials. Some businesses may shorten their operating cycle and generate more working capital by asking for payment before delivery, reducing credit terms, or billing upon arrival. By applying these changes, businesses can liberate additional cash to increase cash flow.
How to calculate working capital
Here are the steps to identify the components and apply them to the formula to calculate working capital:
1. Calculate the current assets
The first section of the formula for calculating working capital is the company's current assets. To calculate the current assets on a company's balance sheet, you can combine the inventory on hand, accounts receivable, short-term securities, and cash. Here is an example to consider:
A puzzle manufacturing company's accountant reviews the balance sheet to determine the company's current assets. They combine the values of $45,000 in current inventory, $76,000 in accounts receivable, $32,000 in short-term securities, and $34,500 in cash to determine a total assets value of $187,500.
2. Calculate current liabilities
The second step in evaluating a company's working capital is identifying its current liabilities. These are typically short-term obligations expected to be repaid within the year. Combine the amount owed to current accounts payable, accrued liability payments, and other short-term debts to determine the current liabilities. Here's an example to demonstrate:
The puzzle manufacturer's accountant reviews the balance sheet to calculate its current liabilities. They identify the current accounts payable as $43,000, accrued liability payments as $22,100, and $23,000 in taxes payable. They combine these values to conclude the company's current liabilities are $88,100.
3. Input the values into the working capital formula
Once you have determined the values for a company's current assets and liabilities, you can input the values into the working capital formula. By subtracting the current liabilities from the current assets, you can determine the net working capital. Here is the formula, followed by a continuation of the example:
Current assets – Current liabilities = Working capital
The accountant subtracts the puzzle manufacturer's current liabilities of $88,100 from its current assets of $187,500. They determine the company's working capital is $99,400. Since the value is positive, the accountant concludes the manufacturer has enough assets to cover its short-term obligations.
4. Interpret the results
If the working capital is negative, it indicates that the business might be in imminent financial trouble. In these cases, business leaders may choose to increase the company's cash flow or refinance their current debt to manage the company's capital. Conversely, if the working capital is positive, this indicates the business currently has enough assets to cover its liabilities in the short term.
Reasons a business might require additional working capital
Working capital is important because it allows businesses to remain solvent. Companies using working capital inefficiently may experience limitations when seeking additional financing to grow the business or capitalize on new opportunities. Businesses may require additional working capital to improve their plant, pursue new offerings, or develop new products or services. Here are some additional reasons why a business might require additional working capital:
To pay expenses when they come due if the business is waiting on customer payment
To take advantage of significant discounts from suppliers for bulk purchases
To cover specific project-related expenses outside of the regular business operations
To account for seasonal changes in a business cycle or to prepare for an upcoming busy period
Example of working capital
Here is an example of working capital occurring:
A construction company is preparing for a busy home-building season and wants to ensure it has enough assets to cover its current liabilities and purchase new materials. The business owner engages their accountant to calculate their net working capital. The accountant reviews the balance sheets to determine total assets of $1,750,000, based on $500,000 in cash, $250,000 in accounts receivable, and $1,000,000 in current inventory.
They then determine the company's current total liabilities of $550,000, based on $400,00 in accounts payable, $50,000 in short-term debts, and $100,000 in accrued liabilities. The accountant deduces that the company's working capital is $1,200,000.
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