What is working capital?
Working capital is liquid funds/assets that can be used for daily operations. It is the difference between current assets and current liabilities and a measure of a company’s current liquidity.
The 2 key components of working capital
Current assets and current liabilities are the two components of working capital. In this section, you’ll get to know what each is, then we’ll see how they come together to create working capital.
Current assets are also consumed, sold, used, or exhausted within one year as part of daily operations. Being an asset, current assets appear on the balance sheet. They consist of:
Stocks and bonds
Current assets can quickly be turned to cash and are sometimes referred to as liquid assets.
Current liabilities are also on the balance sheet. They are financial obligations that are due within one year. Current liabilities include:
Current liabilities are paid with current assets.
How to calculate working capital
The following formula is used to calculate working capital:
Net working capital = current assets - current liabilities
As you can see, it is simply the difference between current assets and liabilities. Since working capital is dependent on current assets and liabilities, this also means it is “current.” In other words, working capital is always dealing with a short-term time frame.
It is immediate cash to meet immediate obligations. Immediate obligations never go away and must be handled daily. This is why cash flow is called the lifeblood of a business. Without cash flow, a business will quickly seize up and cease to exist. Working capital is dependent on cash flow. It’s cash flow that fills the coffers of working capital.
How does working capital affect business operations?
Any business that wants to grow and build out a network of suppliers needs working capital. It allows a business to pay for short-term expenses. It is also used by suppliers to evaluate the financial health of a business. Suppliers want to ensure that they are dealing with a reliable business and that they’ll get paid on time. Analyzing a potential customer’s working capital provides the necessary insights into the efficiency of a business. Of course, further analysis is needed to determine overall creditworthiness.
Companies with net positive working capital can more easily obtain credit than those with negative working capital. Some suppliers will go further than determining if a business has only positive working capital. The amount of working capital is also factored into how much credit a company will receive. This is generally determined using an average working capital that is based on industry and company size.
It’s also easier to find suppliers when a company has net positive working capital. In contrast, net negative working capital is a sign of a less stable business and one that suppliers will be more reluctant to work with. Overall, positive working capital can help a business grow, whereas negative working capital can constrain it.
More working capital means more cash-on-hand to expand into new ventures. While working capital is mostly used for short-term needs, as a company grows and is able to consistently build up its working capital, more money is available to help with its expansionary needs. Working capital that goes beyond what is required for short-term obligations can be used to help grow the company. In some cases, when a company has enough working capital, it can forego loans in place of its available cash.
Working capital shouldn’t be confused with cash. Cash is a component of working capital and there is no minimum or maximum cash percentage. Some companies may have a lot of working capital but very little cash. This would mean they have more short-term non-cash assets. If the company needs cash, it would have to convert these assets into cash, which shouldn’t be a problem since they are liquid assets.
Why companies need to track their working capital
Working capital is both a performance metric and a key indicator. The efficiency of a business can be tracked by changes in the trend of its working capital. Increasing working capital may be a sign of dropping expenses or increased cash flow. Decreasing working capital can mean short-term liabilities are overtaking short-term assets. As well, since working capital is necessary for a business to operate, it’s always important to understand what this indicator is saying.
Determine cash flow
Cash flow is a critical part of a business's financial health, and tracking working capital helps you understand cash flow. As mentioned earlier, cash flow is the lifeblood of any business and the source of working capital. Understanding the trend of cash flow will help determine future working capital.
Gauge overall efficiency & profitability
Working capital is a decent general measure of business efficiency and profitability. A business that isn't producing cash flow can still have working capital. However, it will be diminishing every month. Diminishing or deficient working capital signifies that cash flows are absent or current liabilities are eating up all working capital. Both are adverse scenarios.
Understanding the trend in working capital provides feedback about how efficiently a business is performing. A quick drop in working capital might be explained by money shifting to expansion projects, which is a net positive for the business. If the drop were due to an increase in debt services, that would indicate the business is running poorly — working capital is being rapidly depleted for non-productive use (i.e., loan payments).
A company that is able to sustain a consistent level of working capital shows that it has good cash flow and is in control of its expenses. There’s money remaining for expansion as well. As with many business performance metrics, following the trend over a period of time can help to reveal potential trouble or that the business is improving.
Conduct risk analysis
Higher working capital typically means less risk. This is because working capital can act as a cushion against unforeseen expenses. This scenario is especially helpful for companies that don't have access to credit. For those companies, building up above-average working capital will help to offset financial shocks.
Expand into new markets or develop new products
If you want to expand your business, you’ll likely need working capital or access to credit. This is similar to buying a home. Most people who want to buy a home can only afford a down payment. The balance is provided by a loan (i.e., mortgage). Similarly, businesses that want to expand need access to far more funds than they have available.
While a company’s working capital may not be enough to pay for expansion, it can help the company to get a loan. Lenders will evaluate a company’s working capital as a main lending decision factor. The better maintained a company’s working capital is, the more likely the company is to get approved for a loan and the more loan it is likely to get.
Working capital is essential to the efficient operation of any business. Without working capital, a business isn’t able to pay for its short-term financial obligations, gain access to credit, or get approved for loans. No working capital can be a sign that short-term liabilities are unsustainable.
Working capital is fed by cash flow, which means positive cash flow is required to maintain working capital. Working capital is also an important metric in evaluating business performance.