Working capital
Working capital refers to the funds that a company has available for its short-term financial obligations and operational expenses. It is calculated by subtracting current liabilities—debts a company owes—from current assets, which represent what the company owns. This financial metric is crucial for assessing a company's liquidity and overall financial health, as it indicates the ability to cover immediate costs such as bills and inventory purchases. A business with positive working capital demonstrates effective financial management, while negative working capital suggests potential issues, such as insufficient income or excessive spending. The management of working capital varies by industry and is influenced by factors such as cash flow from sales and payment terms with suppliers. Regular monitoring and strategic use of working capital can help businesses maintain operational efficiency and respond effectively to unforeseen expenses. Ultimately, working capital serves as a vital indicator of a company's financial stability and its capacity to sustain operations in the short term.
On this Page
Subject Terms
Working capital
Working capital is cash that is readily available to a company for short-term or sudden expenses. Working capital is calculated by subtracting the company's current liabilities, or debts, from the company's total assets. Working capital generally is not intended to be saved long-term, but rather to be used for immediate expenses such as paying bills, purchasing more inventory, or meeting sudden and unforeseen financial obligations. Companies may calculate their working capital using balance sheets, which add the companies' sources of income and other assets and then subtract all the money the company owes to outside entities. The figure that remains after the subtractions is the company's working capital.
Companies can estimate their financial stability by calculating their working capital. This is because arriving at this figure requires examining recent company activities, such as the production of revenue and the management of inventory and debts. Companies whose liabilities exceed their assets are said to have negative working capital. This could be because sales have slumped or because the company is paying its debts too quickly or collecting its debts too slowly. Working capital that increases over time usually indicates a company is performing well.
Background
Working capital is found using the following formula: current assets - current liabilities = working capital. Current assets may also be known as gross working capital. This figure is composed of every dollar a company owns, without taking into account the debts the company owes to other institutions. These debts compose current liabilities. The working capital found at the end of the formula indicates the business's true financial strength.
For example, if a company's gross working capital is $10,000 and the company owes $5,000 in debts, the company's working capital is $5,000. How the business spends these funds depends on the nature of the business and what the owner's plans are for its future. Some of this will likely be used for resupply, while some may be invested in expansion. Inversely, if a business's gross working capital is $5,000 and the business owes $10,000 in debts, the business has -$5,000 in working capital.
Negative working capital is considered undesirable, as it means a company is not performing well and cannot pay bills or employee salaries or handle unplanned expenses. At the same time, too much working capital can also be a detriment, as it indicates a company is hoarding cash that could be growing in investments.
A working capital figure is useful in describing a company's liquidity and level of financial efficiency. Liquidity is an entity's ability to convert assets into cash at fixed prices. Finding an organization's working capital usually involves a kind of audit of all the organization's financial activities to determine why the final figure is what it is. The working capital figure takes into account cash, inventory, money the company owes (accounts payable), money the company is owed (accounts receivable), and various other briefly held debts such as utility bills. Consequently, calculating a business's working capital usually necessitates a thorough examination of the business's regular practices, including how the organization manages its inventory and debts and pays its suppliers.
Several factors generally influence how businesses should tailor their approaches to working capital management. The specific industry of a business will determine which factors apply. For instance, when calculating how much working capital to have ready at any given time, a business manager should first consider where most of the company's financial assets are located. If a significant portion of assets are in cash or cash equivalents such as coins or uncashed checks, then the company might not need a large supply of working capital. This is because cash assets are always primed for spending and can be accessed relatively quickly. However, business owners may discover that liquidating assets simply to pay liabilities is not always a wise decision, since cash is continually needed for employee payroll and other regular expenses.
Another factor influencing the size of a company's working capital is the way customers pay for their goods or services. A business that conducts all its activities online and is paid via credit cards may need either a large or small amount of working capital, depending on how soon the credit card companies actually pay the business. If the business gets paid before its debts to suppliers are due, the business will likely not need as much working capital on hand. If the business gets paid after its debts are due, it will need more working capital. Finally, if a company possesses a line of credit and can consistently and reasonably purchase supplies with that credit, the company will not need substantial working capital at the ready.
Overview
Continuously managing working capital should be a vital concern of every business leader. While the funds exist primarily to pay for fleeting expenses such as bills and supplier invoices, the ways in which a company's working capital changes over time can indicate the financial health of the company. Working capital that is shrinking or found already to be in the negative can signal the presence of numerous undesirable situations. One of these is that the business is regularly spending more than it is earning in revenue. Another is that the business is failing to sustain and/or increase sales over time.
Business owners may also find that, while sales are strong, they are simply spending too much working capital on expansion. This problem can result from the owners using cash for all of their expenses instead of taking out loans from a bank. Loans would require the company to pay back the bank with interest, but the payments could be made at regular intervals over time, thereby freeing more working capital to be used for other responsibilities.
In some cases, certain businesses may succeed without much working capital at all. This applies principally to companies that make most of their money in cash, such as discount retailers and grocery stores. Companies such as these essentially make money every day without tremendous effort, and the cash they make is quickly reinvested in more supplies that will only drive sales further. Therefore, these sorts of businesses would not benefit from stockpiling a great amount of working capital.
Bibliography
Ashworth, Mike. "Working Capital Management." Association of Chartered Certified Accountants, www.accaglobal.com/us/en/student/exam-support-resources/fundamentals-exams-study-resources/f9/technical-articles/wcm.html. Accessed 18 Dec. 2024.
Averkamp, Harold. "What Is Working Capital?" Accounting Coach, www.accountingcoach.com/blog/what-is-working-capital. Accessed 18 Dec. 2024.
Beaver, Scott. “What Is Working Capital? How to Calculate and Why It's Important.” NetSuite, 21 Aug. 2022, www.netsuite.com/portal/resource/articles/financial-management/working-capital.shtml. Accessed 18 Dec. 2024.
Fernando, Jason. "Working Capital: Formula, Components, and Limitations." Investopedia, 27 June 2024, www.investopedia.com/terms/w/workingcapital.asp. Accessed 18 Dec. 2024.
Hwang, Robert. "Working Capital." InvestingAnswers, 30 Nov. 2020, www.investinganswers.com/financial-dictionary/financial-statement-analysis/working-capital-869. Accessed 18 Dec. 2024.
Kennon, Joshua. "What is Working Capital." The Balance, 16 Sept. 2022, www.thebalance.com/how-to-calculate-working-capital-on-the-balance-sheet-357300. Accessed 18 Dec. 2024.
Keythman, Bryan. "How to Calculate and Interpret a Company's Net Working Capital." Chron, smallbusiness.chron.com/calculate-interpret-companys-net-working-capital-16051.html. Accessed 18 Dec. 2024.