Working capital assesses a company's ability to pay its current liabilities with its current assets, giving us an indication of the subject’s short-term financial health, capacity to clear its debts within a year, and operational efficiency.
Working capital represents the difference between a company’s current assets and current liabilities. The challenge here is determining the proper category for the vast array of assets and liabilities on a corporate balance sheet and deciphering the overall health of a company in meeting its short-term commitments.
- Working capital is the amount of available capital that a company can readily use for day-to-day operations.
- It measures a company's liquidity, operational efficiency, and short-term financial health.
- To calculate working capital, compare a company's current assets to its current liabilities, for instance by using the current ratio.
Components of Working Capital
This is what a company currently owns—both tangible and intangible—that it can easily turn into cash within one year or one business cycle, whichever is less. Obvious examples of current assets include checking and savings accounts; highly liquid marketable securities such as stocks, bonds, mutual funds and exchange-traded funds (ETFs); money market accounts; cash and cash equivalents, accounts receivable, inventory, and other shorter-term prepaid expenses.
Other examples include current assets of discontinued operations and interest payable. Remember, current assets are resources that can be converted into cash fairly quickly and, therefore, do not include long-term or illiquid investments such as certain hedge funds, real estate, or collectibles.
In a similar fashion, current liabilities are all the debts and expenses the company expects to pay within a year or one business cycle, whichever is less. This typically includes the normal costs of running the business such as rent, utilities, materials and supplies; interest or principal payments on debt; accounts payable; accrued liabilities; and accrued income taxes.
How to Calculate Working Capital
Working capital is calculated by using the current ratio, which is current assets divided by current liabilities. A ratio above 1 means current assets exceed liabilities, and, generally, the higher the ratio, the better.
Current Ratio=Current LiabilitiesCurrent Assets
Working Capital Example: Coca-Cola
For the fiscal year ending December 31, 2017, The Coca-Cola Company (KO) had current assets valued at $36.54 billion. They included cash and cash equivalents, short-term investments, marketable securities, accounts receivable, inventories, prepaid expenses, and assets held for sale.
Coca-Cola also registered current liabilities for the fiscal year ending December 2017 equaling $27.19 billion. The company’s current liabilities consisted of accounts payable, accrued expenses, loans and notes payable, current maturities of long-term debt, accrued income taxes, and liabilities held for sale.
Based on the information above, Coca-Cola’s current ratio is 1.34:
$36.54 billion ÷ $27.19 billion = 1.34
Does Working Capital Change?
While working capital funds do not expire, the working capital figure does change over time. That's because a company's current liabilities and current assets are based on a rolling 12-month period.
The exact working capital figure can change every day, depending on the nature of a company's debt. What was once a long-term liability, such as a 10-year loan, becomes a current liability in the ninth year when the repayment deadline is less than a year away. Similarly, what was once a long-term asset, such as real estate or equipment, suddenly becomes a current asset when a buyer is lined up.
Working capital as current assets cannot be depreciated the way long-term, fixed assets are. Certain working capital, such as inventory and accounts receivable, may lose value or even be written off sometimes, but how that is recorded does not follow depreciation rules. Working capital as current assets can only be expensed immediately as one-time costs to match the revenue they help generate in the period.
While it can't lose its value to depreciation over time, working capital may be devalued when some assets have to be marked to market. That happens when an asset's price is below its original cost, and others are not salvageable. Two common examples involve inventory and accounts receivable.
Inventory obsolescence can be a real issue in operations. When that happens, the market for the inventory has priced it lower than the inventory's initial purchase value as recorded in the accounting books. To reflect current market conditions and use the lower of cost and market method, a company marks the inventory down, resulting in a loss of value in working capital.
Meanwhile, some accounts receivable may become uncollectible at some point and have to be totally written off, representing another loss of value in working capital. As such losses in current assets reduce working capital below its desired level, it may take longer-term funds or assets to replenish the current-asset shortfall, which is a costly way to finance additional working capital.
Working capital should be assessed periodically over time to ensure no devaluation occurs and that there's enough of it left to fund continuous operations.
What Working Capital Means
A healthy business will have ample capacity to pay off its current liabilities with current assets. A ratio of above 1 means a company's assets can be converted into cash at a faster rate. The higher the ratio, the more likely a company can honor its short-term liabilities and debt commitments.
A higher ratio also means the company can easily fund its day-to-day operations. The more working capital a company has, the less it’s likely to have to take on debt to fund the growth of its business.
A company with a ratio of less than 1 is considered risky by investors and creditors since it demonstrates that the company may not be able to cover its debt if needed. A current ratio of less than 1 is known as negative working capital.
We can see in the chart below that Coca-Cola's working capital, as shown by the current ratio, has improved steadily over the last few years.
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 quick ratio excludes inventory, which can be more difficult to turn into cash on a short-term basis.