WHAT IS WORKING CAPITAL (WC)?

Working capital, also known as net working capital (NWC), is the difference between a company’s current assets (cash, accounts receivable/customers’ unpaid bills, inventories of raw materials and finished goods) and its current liabilities, such as accounts payable and debts.

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Working capital is a measure of a company's liquidity, operational efficiency, and short-term financial health. If a company has substantial positive working capital, then it should have the potential to invest and grow. If a company's current assets do not exceed its current liabilities, then it may have trouble growing or paying back creditors, or even go bankrupt.

KEY TAKEAWAYS

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• Working capital, aka net working capital (NWC), represents the difference between a company’s current assets and current liabilities.

• NWC is a measure of a company's liquidity and short-term financial health.

• A company has negative working capital if its ratio of current assets to liabilities is less than one.

• Positive working capital indicates that a company can fund its current operations and invest in future activities and growth.

• High working capital isn't always a good thing. It might indicate that the business has too much inventory or is not investing its excess cash.

Understanding Working Capital

Current assets listed include cash, accounts receivable, inventory, and other assets that are expected to be liquidated or turned into cash in less than one year. Current liabilities include accounts payable, wages, taxes payable, and the current portion of long-term debt, due within one year.

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To calculate working capital, compare the former to the latter—specifically, subtract one from the other. The standard formula for working capital is current assets minus current liabilities. A company has negative working capital if its ratio of current assets to liabilities is less than one.

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Positive working capital indicates that a company can fund its current operations and invest in future activities and growth.

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Working capital that is in line with or higher than the industry average for a company of comparable size is generally considered acceptable. Low working capital may indicate a risk of distress or default.

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Special Considerations

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Most major new projects, such as an expansion in production or into new markets, require an investment in working capital. That reduces cash flow. But cash flow will also fall if money is collected too slowly, or if sales volumes are decreasing—which will lead to a fall in accounts receivable. Companies that are using working capital inefficiently can boost cash flow by squeezing suppliers and customers.

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On the other hand, high working capital isn't always a good thing. It might indicate that the business has too much inventory or is not investing its excess cash.

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How Do You Calculate Working Capital?

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Working capital is calculated by taking a company's current assets and deducting current liabilities. For instance, if a company has current assets of $100,000 and current liabilities of $80,000, then its working capital would be $20,000. Common examples of current assets include cash, accounts receivable, and inventory. Examples of current liabilities include accounts payable, short-term debt payments, or the current portion of deferred revenue.

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What Is an Example of Working Capital?

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Consider the case of XYZ Corporation. When XYZ first started, it had working capital of only $10,000, with current assets averaging $50,000 and current liabilities averaging $40,000. In order to improve its working capital, XYZ decided to keep more cash in reserve and deliberately delay its payments to suppliers in order to reduce current liabilities. After making these changes, XYZ has current assets averaging $70,000 and current liabilities averaging $30,000. Its working capital is, therefore, $40,000.

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Why Is Working Capital Important?

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Working capital is important because it is necessary in order for businesses to remain solvent. In theory, a business could become bankrupt even if it is profitable. After all, a business cannot rely on paper profits in order to pay its bills—those bills need to be paid in cash readily in hand. Say a company has accumulated $1 million in cash due to its previous years’ retained earnings. If the company were to invest all $1 million at once, it could find itself with insufficient current assets to pay for its current liabilities.