What Is Working Capital?

Working capital glossary

• Balance sheet: a financial statement that lists a company's assets, liabilities, and shareholders' equity (It includes both short- and long-term company assets.)
• Current assets: assets that a company can convert into cash within a year
• Current liabilities: liabilities that are due within a year
• Current ratio: current assets divided by current liabilities
• Net working capital (NWC): another term for working capital (The terms are used interchangeably.)
• Gross working capital: the sum of all current assets
• Working capital: the difference between current assets and liabilities

What is net working capital?

Net working capital, which is synonymous with working capital, is an important financial metric that reflects a company’s short-term financial health. Calculating it involves finding the difference between current assets and liabilities.

Current liabilities

Current liabilities are short-term financial obligations that a company must meet within one year. For any given company, they can include:

• Payroll
• Accounts payable
• Income taxes
• Rental fees
• Short-term debt

Ideally, current assets should cover current liabilities.

Current assets

Current assets are assets a company can convert into cash within one fiscal year as part of its regular operating cycle. They usually include:

• Cash
• Accounts receivable
• Prepaid liabilities
• Stock inventory
• Marketable securities

These assets allow companies to manage their daily expenses and cover short-term financial obligations.

The importance of working capital

Working capital is important because it allows a business to stay afloat if it suddenly runs into cash flow problems. Companies with a positive working capital can pay employees, suppliers, and taxes and meet other obligations, as well as grow and develop without incurring debt. In the event it wants to borrow money, a business with a positive working capital can qualify for loans much easier than a company with a negative one.

Working capital is also an important tool because it helps even out revenue fluctuations. Businesses that experience revenue ups and downs due to seasonality require positive working capital to meet their short-term obligations.

For example, some retailers receive 50% of their revenue during the fall and winter holiday seasons but must pay salaries, rent and taxes all year round. By ensuring a positive working capital, these retailers make regular payments and have sufficient resources to prepare for the new season.

What is the working capital formula?

The working capital formula is simple:

Current assets – current liabilities = working capital

For example,
A company’s current assets are:

• Cash: $10,000
• Accounts receivable: $20,000
• Stock inventory: $20,000

Total = $50,000

The company’s current liabilities are:

• Accounts payable: $15,000
• Rent: $10,000
• Income taxes: $5,000

Total = $30,000

Working capital = $50,000 – $30,000 = $20,000

Calculating the working capital gives businesses a clear understanding of how many short-term liquid assets they have available after covering their short-term liabilities. This information is vital for performing financial analysis, managing cash flow and making financial predictions.

Positive vs. negative vs. neutral working capital

In the above example, the working capital is positive, meaning that the company has sufficient liquid assets to pay its current debt and "extra" assets to cover unexpected expenses. However, it can also be negative or neutral.

Positive working capital

If you receive a positive figure after subtracting current liabilities from current assets, you have positive working capital. A positive working capital indicates that a company has capital to work with.

It can use this money for investments, product development, new projects and more. However, if a company is holding on to excess working capital without making any efforts to use it, it’s missing opportunities for growth.

Negative working capital

Negative working capital means a company can't cover its immediate debt with its current assets. To cover the current debt, it would need to make an extra effort, such as taking out a loan.

A negative figure doesn't always mean a company has financial problems. If there is a negative change in the working capital, it's usually due to an increase in the accounts payable (e.g., a large purchase) or a sharp decrease in accounts receivable (e.g., loss of a client).

However, if working capital remains negative over a long period, it could indicate a problem. If a company relies on loans or stock issuances to cover its current liabilities, it needs to review its business strategy. Continuous working capital issues leave companies unable to grow and develop since all current assets go toward operational costs.

Neutral working capital

If a company’s current assets equal its current liabilities, its working capital is neutral. While this may seem like a perfect situation, it could pose a certain danger to the company's financial integrity.

For example, the company may not be able to convert some of its current assets into cash fast enough to cover current liabilities, which would require quick actions, such as taking out loans or pushing through sales. Keeping extra current assets available ensures companies can deal with short-term expenses.

Neutral working capital also prevents companies from driving growth and development, which could raise a red flag for investors.

Exceptions

Negative, small or neutral working capital isn't always a bad thing. For some companies, this metric doesn’t indicate financial weakness. This usually applies to businesses that can generate cash quickly because they have a high inventory turnover rate and receive payments from clients quickly.

An example is the fast-food chain Subway. It sells every product it receives from its suppliers before having to pay the vendor.

Changes in working capital

It's natural for a company's working capital to fluctuate over time due to different operational situations. Many businesses face short-lived periods of negative working capital alongside periods of positive working capital.

However, each period of negative working capital deserves close attention. Failing to do something to turn the problem around could lead to significant problems in the future.

Meanwhile, changes in working capital reflect how a company is operating. If a company has too much working capital, it is hindering business growth and development by taking an excessively conservative approach. If it has too little working capital, it may be acting too aggressively with its finances.

Working capital vs. current ratio

The current ratio (also called working capital ratio) is a financial ratio measuring a company's ability to meet short-term obligations. It serves essentially the same purpose as the working capital by reflecting a company's financial health.

The formula for the current ratio is:

Current assets / current liabilities = current ratio

If the current ratio is less than one, a company lacks sufficient capital to meet its short-term obligations. A current ratio of more than one indicates a company's ability to cover its short-term liabilities.

What is a good working capital ratio?

While a good working capital ratio differs from company to company, most business owners strive to keep it between 1.5 and 2.

Net working capital vs. gross working capital

Gross working capital is a metric that reflects the total sum of a company's assets without considering liabilities. It’s an important metric that allows companies to evaluate their financial health, but it's not as detailed as net working capital.

For example, a gross working capital of $300,000 may seem like a lot. However, if the company’s liabilities equal $400,000, its financial situation isn't in top shape.
Although gross working capital isn't a useful metric on its own, it can provide an excellent picture of a company's liquidity when coupled with other information, including NWC.

Staying on top of working capital

Working capital is an important indication of a company's financial health. By evaluating it regularly and implementing top-notch working capital management, companies can streamline financial integrity and ensure stability and growth.

While not always bad, continuous negative working capital can signal serious problems. Preventing them involves adjusting the approach to current assets and current liabilities.