Working capital: formula and definition

What is working capital?

Working capital is an accounting measure that refers to the amount of liquid assets a company needs to deploy over the next 12 months relative to its short-term financial obligations for the same period. It indicates whether the reserve of cash that a company has or expects to receive in the following year is sufficient to meet the short-term obligations that it also expects to meet during this period.

Working capital is calculated as part of a company’s balance sheet and includes a company’s assets and liabilities over the next 12 months. While the equations for calculating working capital are straightforward, most businesses have considerable cash inflows and outflows, many of which have some degree of uncertainty about timing. This makes working capital an ever-changing amount. However, keeping pace with its momentum is important for a company’s management and financial departments to ensure that they are using their cash efficiently and meeting their obligations.

The amount of working capital a business needs often depends on the industry and how things are made, paid for, and sold in that industry. For example, businesses in seasonal industries might need more working capital at the start of the season because they won’t receive payments from customers until later in the season. Considerable working capital could also be required by companies that need to take advantage of supplier discounts by buying or manufacturing in bulk to keep margins low. To know how a company achieves this metric, it is important to compare its working capital to the average for its industry.

Carry: Working capital is the amount a business has in the form of short-term liquid assets after paying its short-term debts. It determines a company’s immediate liquidity and is often used to manage cash flow and for other forms of financial analysis.

2 Components of working capital

Current assets and current liabilities are the two main components of working capital:

1. Current assets

A company current assets include all of its:

  • Cash and cash equivalents
  • Prepaid expenses
  • Inventory expected to be sold within 12 months
  • Marketable securities
  • Stationery
  • Accounts Receivable
  • Assets he expects to be able to liquidate within 12 months

It could also include less common assets like property a business is about to sell or the cash value of life insurance.

Takeaway key: Current assets represent the amount of cash a business has or will have on hand to pay its expenses.

2. Current liabilities

A company current liabilities are all bonds of the company that will mature within 12 months of the balance sheet date. This could include all:

  • Debt payments due
  • Accounts payable
  • Salaries and social charges
  • Invoices
  • Other taxes
  • Customer deposits
  • Deferred revenue
  • Big purchases

It could also include less common expenses like bank overdrafts, declared dividends, and judgments against a business.

Takeaway key: Current liabilities represent the total expenses that a business will have to pay over the next 12-month period.

How working capital is calculated

Working capital is then calculated by subtracting liabilities from assets as follows:

Working capital = Current assets – Current liabilities

This equation finds a company’s current amount of working capital and is sometimes also called the net working capital formula.

However, net working capital can also be calculated in other ways, depending on how a particular industry likes to see it.

Alternative net working capital formulas include:

Net working capital = Current assets (less cash) – Current liabilities (less debt)

Net working capital = Accounts Receivable + Inventory – Accounts Payable

Working capital ratio (current ratio)

A finance manager of a company may also want to know the amount of working capital the company has relative to the size of its liabilities to understand the strength of a company’s working capital relative to its expenses. For this, a working capital ratio can also be calculated. The equation for this calculation is:

Working capital ratio = Current assets / Current liabilities

The working capital ratio (also called Current Ratio) provides the percentage of excess or deficiency of working capital in relation to its liabilities or assets.

For example, if a business has $100,000 in current assets and $90,000 in liabilities, the business has working capital of $10,000 but a working capital ratio of 110%.

$100,000 / $90,000 = 110%

If this company is in an industry where the average working capital of its competitors is 130%, then this company could face problems growing or paying its bills if faced with an unexpected opportunity or expense. .

Example of working capital

Working capital is not a static number and can change during the year as outputs and inputs change.

Finding working capital: example

For example, suppose Acme Corp’s current assets are $85,000 and current liabilities are $75,000.

$85,000 – $75,000 = $10,000

Current assets $
Cash $10,000
Accounts Receivable $30,000
Prepaid expenses $5,000
Inventories $30,000
Current assets $10,000
Total current assets $85,000

Current liabilities $
Accounts payable $30,000
Debt payments $5,000
Dividends declared $20,000
Taxes $20,000
Total current liabilities $75,000

Total current assets $85,000
Total current liabilities ($75,000)
Working capital $10,000

Change in working capital: example 1

Next, suppose Acme Corp unexpectedly receives a large order for its widgets that requires them to manufacture more goods for which they must pay in advance. Since they only have $10,000 in working capital, they decide to take out a loan of $50,000 in order to have enough to pay for their order. However, they will receive $90,000 for the order in 6 months. Here’s how the loan, expected accounts receivable, and new manufacturing expenses change Acme Corp’s working capital calculation:

$225,000 – $125,000 = $100,000

However, you can also use changes in the working capital formula to calculate it if you want to understand how working capital changes.

Changes in working capital = Changes in current assets – Changes in current liabilities

$140,000 – $50,000 = $90,000

Current assets $
Cash $60,000
Accounts Receivable $120,000
Prepaid expenses $5,000
Inventories $30,000
Current assets $10,000
Total current assets $225,000

Current liabilities
Accounts payable $80,000
Debt payments $5,000
Dividends declared $20,000
Taxes $20,000
Total current liabilities $125,000

Total current assets $225,000
Total current liabilities ($125,000)
Working capital $100,000

Change in working capital: example 2

However, once Acme Corp is paid for its goods, its working capital changes again.

$175,000 – $125,000 = $50,000

Change in working capital = Changes in current assets – Changes in current liabilities

$50,000 – $0 = $50,000

Current assets $
Cash $10,000
Accounts Receivable $120,000
Prepaid expenses $5,000
Inventories $30,000
Current assets $10,000
Total current assets $175,000

Current liabilities
Accounts payable $80,000
Debt payments $5,000
Dividends declared $20,000
Taxes $20,000
Total current liabilities $125,000

Total current assets $175,000
Total current liabilities ($125,000)
Working capital $50,000

Carry: Working capital is not a static number, but changes as a business spends or receives money and its current asset and liability position changes.

How working capital is used

Working capital is used by businesses for the following reasons:

  • To better understand how capable they are meet financial obligations or take advantage of opportunities over the next 12 months.
  • To anticipate possible future financial difficulties. If a company’s working capital is negative, it will need to find a way to access more working capital using tactics such as getting a loan, selling assets, laying off staff or selling more inventory.
  • To compare with other companies: Management and investors may be interested in knowing how a company’s working capital position compares to that of its competitors or to anticipated changes or events in its industry.

Investors should be interested in working capital since it is a measure of a company’s liquidity and short-term financial health. If a business has low working capital, it risks defaulting on debt or going bankrupt. If a business has above-average working capital, it may not be using its capital efficiently for growth and may not be a good investment relative to its competitors.

Carry: Management and investors can use working capital to determine the short-term health or competitive position of a business.

Conclusion

Working capital is an important metric for assessing whether a business can meet short-term financial obligations, meet unexpected expenses, and take advantage of short-term opportunities to save money, generate new business, or serve customers. existing customers.

About Donnie R. Losey

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