Money Matters

What is working capital?

Working capital is a key financial measure for running a healthy business. Learn what it means and how to calculate it.

People in an office

Working capital is not a term that comes up every day in conversation, but it is a key component to your company’s success. Together with cash flow, working capital is what allows you to get a clear view of your company’s financial health.

It affects all aspects of your business, from paying your employees and taxes to making new investments and planning for sustainable long term growth. In short, it is the cash available to meet your current, short term obligations. The aim is for your business to maintain a positive calculation so that you can withstand financial challenges and have the flexibility to invest in growth.

In this article, we explore the topic in detail and explain why it’s such an important financial measure.

What is working capital⁠—and how to calculate it?

Working capital simply means the difference between current assets and current liabilities. So to calculate it, you take your company’s balance sheet and subtract the current liabilities from the current assets. The balance sheet is one of the three primary financial statements that businesses produce; and it shows a snapshot of what your company owns and owes at a moment in time, such as the end of a quarter or fiscal year. The balance sheet includes all the company’s assets and liabilities, both short and long term.

Current assets on the balance sheet include cash and other liquid assets that can be converted into cash within 12 months of the balance sheet date, including accounts receivable, inventory, and prepaid expenses. When you calculate working capital, you are posing the hypothetical situation of the company liquidating all these items into cash. Fixed assets are not included in working capital because they cannot be easily converted to cash. Fixed assets include equipment, real estate, and other tangible assets, as well as intangible assets such as intellectual property (IP) and goodwill.

Current liabilities are all liabilities due within 12 months of the balance sheet date, including accounts payable, taxes, wages, and interest owed. The ultimate goal of working capital is to understand whether your company will be able to cover all these debts with the short term assets it already has on hand.

You will usually state working capital as a dollar figure. For example, say your company has $200,000 of current assets and $50,000 of current liabilities. You would therefore state the company has $150,000 of working capital. This means the company has $150,000 at its disposal in the short term if it needed to raise money for a specific reason.

Why is working capital important?

Having enough working capital is necessary for your company to remain solvent because you need to fund operations and meet short term obligations like interest payments and taxes. Even a profitable business is at risk of becoming bankrupt because bills can’t be paid with the profits shown on an income statement, there needs to be available cash.

If your company has substantial positive working capital, then it has the potential to invest in expansion and grow the company. And if your company does need to borrow money, demonstrating positive working capital can make it easier to qualify for loans or other forms of credit.

The amount of working capital a company has will typically depend on the industry. Retail sectors with thousands of transactions a day will be able to raise short term funds much faster and require lower capital requirements than sectors with longer production cycles that don’t have the quick inventory turnover to generate cash on demand.

Companies can optimize the use of working capital with a working capital management strategy. Effective working capital management enables the business to pay its day-to-day operating costs and ensure the company invests its resources in productive ways. The working capital ratio, also known as the current ratio, is commonly used to assess the company’s working capital. It’s calculated as current assets divided by current liabilities.

If a company’s working capital ratio falls below one, it has a negative cash flow, meaning its liabilities are higher than its current assets. The company cannot cover its debts with its current working capital and will likely have difficulty paying back its creditors. Most analysts consider ratios between 1.5 and 2.0 as ideal, indicating a company is making effective use of its assets. An excessively high ratio, usually greater than 2.0 can indicate the company is not making the best use of its assets, allowing excess cash to sit idle.

Net working capital vs working capital

The terms “working capital” and “net working capital” are often used interchangeably. Both refer to the difference between assets and liabilities. However, the two concepts are in fact different: working capital measures short term liquidity, and net working capital measures overall liquidity.

You can calculate net working capital by subtracting total liabilities from total assets. So unlike working capital, net working capital takes into account fixed assets like property, plant, and equipment as well as long term debt. It is seen as a more forward-looking measure and gives a company a more accurate picture of its overall liquidity.

Positive vs negative working capital

When a working capital calculation is positive, this means current assets are greater than current liabilities. If your company has positive working capital, it has more than enough resources to cover its short term debt, and should all current assets be liquidated to pay the debt, there will be residual cash.

A negative working capital calculation means the current assets, if liquidated, would not cover all the current liabilities. If your company has negative working capital, it has more short term debt than it has short term resources.

This indicates poor short term health, low liquidity, and potential problems paying debt obligations as they become due.

Working capital formula and examples

The working capital formula is:

Working capital = current assets – current liabilities

Using Microsoft as an example, for the quarter ending March 31, 2022, the company reported $153.9 million of current assets. This comprised of cash, cash equivalents, short term investments, accounts receivable, inventory, and other current assets.

The company also reported $77.4 million of current liabilities which included accounts payable, current debts, accrued compensation, income taxes, and other current liabilities.

Microsoft’s working capital at the end of this period was therefore $76.5 million. If Microsoft were to liquidate all short term assets to eliminate all its short term debts, it would have almost $80 million remaining on hand. Another way to think of it is that Microsoft would have enough cash to pay every single current debt twice.

Final thoughts

We’ve established managing working capital is vital for maintaining your company’s health. Positive working capital means you have enough liquid assets to invest in growth while continuing to pay suppliers, employees and make interest payments on loans. In contrast, negative working capital is a warning sign that you may run into cash flow difficulties in the near future, and it’s time to take action.