How do you calculate working capital?

Working capital represents a company's ability to pay its current liabilities with its current assets. Working capital is an important measure of financial health, since creditors can measure a company's ability to pay off its debts in the short term or less than one year. 

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 corporate balance sheet and deciphering the overall health of a firm in meeting its short-term commitments.

Components of Working Capital 

Current Assets

Current assets represent assets – those things a company owns, both tangible and intangible – that the firm can easily, or expects to, turn into cash within one year, or one business cycle, whichever is less. More obvious categories include checking and savings accounts; highly liquid marketable securities such as stocks, bonds, mutual funds and 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 assets do not include long-term or illiquid investments such as certain hedge funds, real estate or collectibles.

Current Liabilities

In similar fashion, current liabilities include all the debts and expenses the firm expects to pay within a year, or one business cycle, whichever is less. This typically includes all 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. Other current liabilities include dividends payable, capital leases due within a year, and long-term debt that is now coming due.

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 the higher the ratio, the better.

Working Capital Example: Coca-Cola

The Coca-Cola Company (KO) had current assets for the fiscal year ending December 31, 2017, valued at $36.54 billion. The current assets included cash and cash equivalents, short-term investments, marketable securities, accounts receivable, inventories, prepaid expenses, and assets held for sale.

Coca-Cola had current liabilities for the fiscal year ending December 2017 equaling $27.19 billion. The current liabilities included accounts payable, accrued expenses, loans and notes payable, current maturities of long-term debt, accrued income taxes, and liabilities held for sale.

Using the information provided about Coca-Cola above, the company's current ratio is:

$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. This is because it is calculated by subtracting a company's current liabilities from its current assets, both of which are based on a rolling 12-month period. In fact, the exact 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 get devalued when some assets have to be marked to market, in which 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, the inventory is marked down, resulting in a loss of value in working capital.

Some accounts receivable may become uncollectible at some point and have to be totally written off the books, 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, a costly way to finance additional working capital.

What Working Capital Means    

• A healthy business will have ample capacity to pay off its current liabilities with current assets. A higher ratio or 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 pay off its short-term liabilities and debt. 
• A higher ratio also means the company can easily fund its day-to-day operations. The more working capital a company has means that it may not have to take on debt to fund the growth of its businesses. 
• 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. (For more on the different types of working capital, check out Can Working Capital Be Negative?

We can see in the chart below that Coco-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.

The Bottom Line

Working capital represents the amount of money a company has left over after accounting for all expenses to be incurred within the next 12 months. It is calculated by subtracting current liabilities from current assets, so it is a reflection of a company's short-term liquidity and operational efficiency.

If current assets are greater than liabilities, the company has positive working capital, meaning it has extra cash on hand to fund growth projects. It also means the company has a nice safety net in place in case it incurs an unexpected expense, such as an unscheduled equipment upgrade or a lawsuit judgment.

Conversely, a company has negative working capital if its current liabilities outstrip its current assets. Though some very large corporations are able to function with negative working capital year after year, it is considered a sign of financial distress for most businesses.

The formula for calculating working capital is straightforward, but lends great insight into the short-term financial health of a company. 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.

The value of working capital should assessed periodically over time to ensure no devaluation occurs, as continuous operations require enough working capital in place.