How Do You Calculate Working Capital?

Working capital represents a company's ability to pay its current liabilities with its current assets. This figure gives investors an indication of the company's short-term financial health, capacity to clear its debts within a year, and operational efficiency.

Working capital is 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 so as to decipher the overall health of a company and its ability to meet its short-term commitments.

Components of Working Capital 

Current Assets

Current assets are assets that a company can easily turn into cash within one year or one business cycle, whichever is less. They do not include long-term or illiquid investments such as certain hedge funds, real estate, or collectibles.

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.

Current Liabilities

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.

Dividends payable, capital leases due within a year, and long-term debt that is now coming due are also current liabilities.

How to Calculate Working Capital

Working capital is calculated simply by subtracting current liabilities from current assets. Calculating the metric known as the current ratio can also be useful. The current ratio, also known as the working capital ratio, provides a quick view of a company's financial health.

You can calculate the current ratio by taking current assets and dividing that figure by current liabilities. A ratio above 1 means current assets exceed liabilities. Generally, the higher the ratio, the better an indicator of a company's ability to pay short-term liabilities.

However, a very high current ratio (meaning a large amount of available current assets) may point to the fact that a company isn't utilizing its excess cash as effectively as it could to generate growth.

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?

The amount of working capital does change over time. That's because a company's current liabilities and current assets are based on a rolling 12-month period and themselves change over time.

Working Capital Can Change Daily

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.

Current Assets Can Be Written Off

Working capital (as current assets) cannot be depreciated the way long-term, fixed assets are. Certain working capital, such as inventory, may lose value or even be written off, but that isn't recorded as depreciation.

Working capital can only be expensed immediately as one-time costs to match the revenue they help generate in the period.

Assets Can Be Devalued

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 a company's 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.

Accounts Receivable May Be Written Off

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.

What Does the Current Ratio Indicate?

A healthy business has working capital and the ability to pay its short-term bills. A current ratio of more than 1 indicates that a company has enough current assets to cover bills coming due within a year. The higher the ratio, the greater a company's short-term liquidity and its ability to pay its short-term liabilities and debt commitments. 

A higher ratio also means the company can continue to fund its day-to-day operations. The more working capital a company has, the less likely it is 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 debts, 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. This indicates improving short-term financial health.

Special Considerations

A more stringent liquidity 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 only cash, marketable securities, and receivables. The quick ratio excludes inventory, which can be more difficult to turn into cash on a short-term basis.