Working capital definition
/What is Working Capital?
Working capital is the amount of an entity's current assets minus its current liabilities. The result is considered a prime measure of the short-term liquidity of an organization. A strongly positive working capital balance indicates robust financial strength, while negative working capital is considered an indicator of impending bankruptcy. When a business has a large positive amount of working capital, it is better able to fund its own expansion without having to obtain debt or equity financing. The operational efficiency, credit policies and payment policies of a business have a strong impact on its working capital.
Note: Current assets are any assets considered to be collectible within one year, while current liabilities are any liabilities expected to be settled within one year.
How to Calculate Working Capital
To calculate the amount of working capital that a business uses, subtract all current liabilities from all current assets. Current assets are usually comprised of cash, marketable securities, and inventory, while current liabilities are comprised of accounts payable, accrued liabilities, and short-term debt. This information can be found on an organization’s balance sheet. Thus, the working capital formula is as follows:
Cash + Marketable securities + Inventory - Accounts payable - Accrued liabilities- Short-term debt = Working capital
There are two concerns with this calculation. One is that the inventory component can be hard to liquidate, especially if it contains a large proportion of old inventory. The other concern is that it may be impossible to collect old accounts receivable, which might really be bad debts. To mitigate these issues, a more accurate working capital formula is to strip old inventory and old receivables from the calculation.
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How to Evaluate Working Capital
A 2:1 ratio of current assets to current liabilities is considered healthy, though the ratio can vary by industry. The ratio may also be reviewed on a trend line, with the intent of spotting any declines or sudden drops that could indicate liquidity problems. If you are evaluating the ability of a business to grow as rapidly as possible, it will need a very high ratio of current assets to current liabilities, since rapid growth requires a substantial investment in working capital. Otherwise, rapid growth will call for external investment in the business. When the ratio is less than 1:1, there is a heightened risk that the business may go bankrupt.
Example of Working Capital
As an example of the calculation of working capital, a business has $100,000 of accounts receivable, $40,000 of inventory, and $35,000 of accounts payable. Its working capital is calculated as follows:
$140,000 Current assets - $35,000 Current liabilities = $105,000 Working capital
The business then collects $20,000 of its accounts receivable and uses the proceeds to pay off $20,000 of its accounts payable. This results in the following working capital calculation:
$120,000 Current assets - $15,000 Current liabilities = $105,000 Working capital
The second part of the example shows that transfers between the classifications result in no net change in the amount of working capital on an organization’s books.
How to Improve Your Working Capital Situation
If a business is experiencing low working capital levels, there are several ways to remediate the situation. One is to delay payments to suppliers, since this is a source of cash. However, it can be difficult to extend payments for very long without incurring the ire of suppliers. Another possibility is to shrink the credit terms of customers, so that they are allowed fewer days before they must pay for purchases made on credit. Again, shrinking credit terms must be used with caution, since excessively short terms may convince customers to buy from competitors offering better credit terms. Yet another possibility is to maintain lower inventory levels, which also reduces the risk of losses due to obsolete inventory. However, a downside of having smaller inventory reserves is the risk of stockouts, which might result in lost sales.
Why You May Need More Working Capital
There are several reasons why your your business may need additional working capital. First, it helps you to take advantage of volume discounts offered by suppliers. These discounts can result in substantial cost reductions, but are only available to those who have enough cash to make large purchases. Second, if your business is seasonal, you will need extra working capital to fund the inventory required for the peak selling season. Otherwise, you may not have enough inventory on hand to meet customer needs, resulting in lost sales. Third, if customers force you to give them long payment terms, then you need more working capital to keep operations running until their payments arrive. This can be a particular problem when selling to large retail chains. Fourth, if your business is growing quickly, the inventory and accounts receivable requirements of the business will call for a substantial boost in working capital. Without it, you will be unable to fund the growth of the business, resulting in minimal expansion. And finally, extra working capital will be needed to fund special projects, such as capital investments. We address this issue in the Project-Related Working Capital section below. In short, businesses routinely need more working capital, for a variety of reasons.
Project-Related Working Capital
When reviewing proposals for investments in new capital projects, be sure to include in the analysis the amount that must be invested in working capital as a result of the investment. This may be a substantial sum, requiring a large cash investment. For example, a proposal to create a new product line will require not only an investment in inventory, but also in new accounts receivable when the goods are sold on credit. These investments will be offset by any accounts payable expected to be owed to suppliers.
The Working Capital Loan
Your business could obtain a working capital loan to meet its working capital needs. It is specifically designed to address short-term operational needs. This means that the loan is usually structured as a line of credit, where the outstanding balance is intended to be paid off at least once a year. A lender is more likely to grant a working capital loan when your business generates positive cash flow, is not excessively leveraged, and has a reasonable history of generating profits for the past few years. In the case of a smaller business, the lender may also ask for a personal guarantee, especially when you have substantial personal assets. A larger firm with a good credit rating may be able to avoid this personal guarantee requirement. If granted, the lender will place restrictions on the size of the loan. As a general rule, most lenders will not grant a working capital loan that exceeds 10% of your organization’s sales.
What is Negative Working Capital?
Negative working capital arises when a business has fewer current assets than current liabilities. It can be triggered by a large cash outflow, such as a quarterly dividend payment or a payment linked to a lost court case. If so, the negative position tends to be short-lived, with normal cash flows gradually rebuilding the firm’s working capital position back into positive territory. However, negative working capital may also be caused by a firm being in poor financial condition, where it is unable to meet its ongoing obligations. If so, the business will need to obtain a cash infusion or alter its business model in order to achieve positive working capital.
An unusual situation is for a business to be operationally sound, and yet still be able to operate with negative working capital. This situation arises when the company’s accounts receivable terms with customers are very short (perhaps even involving prepayments), while its payment terms with suppliers are relatively long. This means that the company receives cash from customers before it has to pay the cash back out to suppliers. In this case, a business can safely maintain a negative working capital position for an extended period of time.
What is Net Working Capital?
Net working capital is the aggregate amount of all current assets and current liabilities. If the net working capital figure is substantially positive, it indicates that the short-term funds available from current assets are more than adequate to pay for current liabilities as they come due for payment. If the figure is substantially negative, then the business may not have sufficient funds available to pay for its current liabilities, and may be in danger of bankruptcy. The net working capital figure is more informative when tracked on a trend line, since this may show a gradual improvement or decline in the net amount of working capital over an extended period.
Terms Similar to Working Capital
Working capital is also known as net working capital.