Working capital refers to any financial resources that are available to fund a business’s ongoing operations.
It is a measure of money that is readily accessible to pay for immediate needs, such as payroll, expenses (both planned and unplanned), and purchases of basic materials that are essential for the business to function.
Working capital is an important metric that reflects the ability of the business to meets these daily needs. A healthy amount of working capital is a reflection of a well-run, efficient business.
For the purposes of measuring working capital, only current assets, or those that can be liquidated in one year or less, are considered. Current assets can include cash, accounts receivable, inventory, cash equivalent in checking and savings accounts, prepaid expenses, inventory, and raw materials.
Working capital is not just a measure of total assets that are accessible to the business. Current liabilities—an obligation for the business to compensate another person or business in monetary terms—must also be considered.
Current liabilities are payable in one year or less. They may include accounts payable, wages, dividends, and short-term debt, such as short-term bank loans, lease payments, and income taxes.
Working capital is derived from the current assets and current liabilities as detailed in the balance sheet. It is calculated by the equation: Working Capital = Current Assets – Current Liabilities. For this reason, working capital is also referred to as net working capital.
For example, a company’s current assets total $1.2 million. Its current liabilities total $850,000. The total working capital is equal to the assets ($1.2 million) minus the liabilities ($850,000), which equals $350,000. This is another way of saying that the business has $350,000 in assets that can be readily converted to cash for short-term needs.
Businesses can also use a working capital ratio. This is calculated by dividing the current assets by the current liabilities. The resulting ratio provides an indicator of the health of the business.
For example, a business with a working capital ratio of less than one has a large amount of current liabilities in proportion to its current assets. A business with a working capital ratio of greater than one has a large amount of current assets in proportion to its current liabilities and is in better financial shape.
A business with a working capital ratio of two or more has a disproportionate amount of current assets in relation to its current liabilities, and may want to invest some of that money on future growth. An ideal working capital ratio is somewhere between one and two.
Businesses need working capital to meet their ongoing needs. Many businesses experience cycles in which revenue fluctuates.
For example, consider a toy company that has most of its sales activity during the Christmas holiday season. Sufficient working capital is needed to allow the company to meet its obligations and stay in operation throughout the year. Salaries must be paid, and purchases must be made all year long.
Working capital enables the business to meet these obligations and prepare for the busy season before sales pick up and revenue is at a peak.
A business may also need working capital to invest in its future growth. Businesses need to stay ahead of the competition. Working capital can be used to invest in inventory, machinery, equipment, or software that will allow the business to anticipate future needs and expand appropriately.
Working capital is an important metric that indicates how well the business is operating.
It is a reflection of the business’ ability to manage and balance many of its integrated operations.
For example, a business that has an effective collections process for accounts receivable, maintains sufficient levels of inventory, and minimizes it debt obligations may see a positive impact on its working capital.
A business that does not have sufficient working capital may not be able to meet its obligations. It could risk insolvency, bankruptcy, and may have to go out of business.
A business may have negative working capital if its current liabilities exceed its current assets.
This might occur when a business makes a large cash payment or when it extends a large amount of credit to customer accounts in its accounts receivable.
Businesses can change or increase working capital in a number of ways. By making adjustments or improvements to any of the balance sheet assets that contribute to working capital, the business can increase the amount of net current assets that it can convert to cash.
For example, the business might increase accounts receivable by increasing sales activity, better managing collections, reducing debt, turning over inventory faster, or delaying payments to vendors by converting to long-term debt.
All of these steps could increase the amount of current assets that the business can convert to cash and invest in its ongoing operations or future growth.