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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.

  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 can working capital be used for?

    Find out what working capital is used for, including how to calculate this financial metric by subtracting current liabilities ... Read Answer >>
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