Loading the player...
A:

Working capital represents the difference between a firm’s current assets and current liabilities. The challenge can be determining the proper category for the vast array of assets and liabilities on a firms’ balance sheet and deciphering the overall health of a firm in meeting its short-term commitments.

Current Assets

Current assets represent assets that a firm expects to turn into cash within one year, or one business cycle, whichever is less. More obvious categories include cash, cash and cash equivalents, accounts receivables, inventory, and other shorter-term prepaid expenses. Other examples include current assets of discontinued operations and interest payable.

Current Liabilities

In similar fashion, current liabilities are liabilities that a firm expects to pay within a year, or one business cycle, whichever is less. Examples include accounts payables, accrued liabilities, and accrued income taxes. Other current liabilities include dividends payable, capital leases due within a year, and long-term debt that is now due within the year.

What Working Capital Means

A healthy business will have ample capacity to pay off its current liabilities with current assets. The current ratio is current assets divided by current liabilities and provides insight into working capital health at a firm. A ratio above 1 means current assets exceed liabilities, and the higher the ratio, the better.

A more stringent ratio is the quick ratio, which measures the proportion of short-term liquidity as compared to current liabilities. The difference between this and the current ratio is in the numerator, where the asset side includes cash, marketable securities, and receivables. The key item it backs out is inventory, which can be more difficult to turn into cash on a shorter-term basis.

The Bottom Line

The formula for calculating working capital is straightforward, but lends great insight into the shorter-term health of a firm. The quick ratio is an even better indicator of shorter-term liquidity and can be important for suppliers and lenders to understand as well as for investors to assess how a company can handle short-term obligations.

RELATED FAQS
  1. What is the formula for calculating the current ratio?

    Find out how to calculate the current ratio and what that result can tell you about a potential investment. Read Answer >>
  2. What are the main differences between the current ratio and the quick ratio?

    Find out how the quick ratio and the current ratio can offer different views on a company's ability to pay off liabilities. Read Answer >>
  3. What are some examples of current liabilities?

    Examine some common examples of current liabilities a company may owe within a year or less in order to accurately assess ... Read Answer >>
  4. Do working capital funds expire?

    Find out how and why a company's working capital can change over time, though the fund does not actually expire, and how ... Read Answer >>
  5. What are some alternative liquidity ratios to the cash ratio?

    Learn what the cash ratio measures, and understand what two other liquidity ratios can be used by a company to replace the ... Read Answer >>
  6. What is the formula for calculating the current ratio in Excel?

    Understand the basics of the current ratio, including its use and interpretation as a financial metric and how it is calculated ... Read Answer >>
Related Articles
  1. Investing

    Current Liabilities

    Current Liabilities are company debts due within one year or one operating cycle, whichever is greater. An operating cycle is the time it takes a company to purchase inventory and convert it ...
  2. Investing

    What's a Liability?

    A liability is a debt. It is an obligation that arises during the course of business and represents a third-party claim on the company's assets. A liability can arise in a number of different ...
  3. Investing Basics

    Do Your Investments Have Short-Term Health?

    If a company is strong enough to survive tough times, it is more likely to provide long-term value.
  4. Economics

    Understanding Total Liabilities

    Total liabilities are the combined debts an individual or company owes.
  5. Economics

    What is the Cash Ratio?

    The cash ratio is the ratio of a company's total cash and cash equivalents to its current liabilities.
  6. Economics

    Explaining Long-Term Liability

    A long-term liability is an obligation a company owes a year or more into the future.
  7. Fundamental Analysis

    5 Basic Financial Ratios And What They Reveal

    Understanding financial ratios can help investors pick strong stocks and build wealth. Here are five to know.
  8. Term

    What Are Quick Assets?

    A company’s quick assets can be easily converted into cash.
  9. Economics

    Explaining Working Capital Turnover

    Working capital turnover is a ratio that helps show how efficiently a company is generating revenue per dollar of cash available to spend on operations.
  10. Fundamental Analysis

    Dynamic Current Ratio: What It Is And How To Use It

    Learn why this ratio may be a good alternative to the current, cash and quick ratios.
RELATED TERMS
  1. Current Liabilities

    A company's debts or obligations that are due within one year. ...
  2. Cash Asset Ratio

    The current value of marketable securities and cash, divided ...
  3. Current Ratio

    The current ratio is a liquidity ratio measuring a company's ...
  4. Other Current Liabilities

    A balance sheet entry used by companies to group together current ...
  5. Long-Term Liabilities

    In accounting, a section of the balance sheet that lists obligations ...
  6. Current Assets

    A balance sheet account that represents the value of all assets ...
Hot Definitions
  1. Physical Capital

    Physical capital is one of the three main factors of production in economic theory. It consists of manmade goods that assist ...
  2. Labor Market

    The labor market refers to the supply and demand for labor, in which employees provide the supply and employers the demand. ...
  3. Demand Curve

    The demand curve is a graphical representation of the relationship between the price of a good or service and the quantity ...
  4. Goldilocks Economy

    An economy that is not so hot that it causes inflation, and not so cold that it causes a recession. This term is used to ...
  5. White Squire

    Very similar to a "white knight", but instead of purchasing a majority interest, the squire purchases a lesser interest in ...
Trading Center