Working capital is the difference between current assets and current liabilities. Prepaid expenses that are due within one year can be counted as current assets in a working capital calculation for that year.

Key Takeaways

  • Working capital is current assets less current liabilities.
  • Prepaid expenses, a current asset, are included in working capital.
  • Working capital helps determine whether a company can meet its short-term obligations.

A Closer Look at Working Capital

We can calculate the working capital of a company as a way to measure its short-term financial health and operational efficiency. The formula for working capital is as follows:

Current Assets - Current Liabilities = Working Capital

Current assets are assets that a company reasonably expects to convert into cash within one year. Current assets can include cash, accounts receivable, and inventory, among others. Current liabilities are a company's bills and other obligations that are due within one year. These include short-term debt and taxes due.

Looking at working capital can help a company understand the strength of its ability to meet its short-term obligations and assess how efficiently the company is using its resources.

This information assists management in making good investment decisions and provides a better understanding of how to manage the business. It also helps investors gauge how effectively management is running the company.

A Closer Look at Prepaid Expenses

Prepaid expenses are costs that have already been paid by a company, but the service or product exchange has yet to occur. Since the prepaid expense is used when the actual expense occurs in the future, it's classified as an asset the company holds on its balance sheet.

If the value exchange for a prepaid expense is expected to occur within a year, then it's considered a current asset, and it can be counted as such when determining working capital.

There are many types of expenses that are often prepaid by companies. Those include rent, utility bills, taxes, and maintenance services. These prepaid expenses can each have their own account within the company's accounting system or be pooled together in one account.

An example of a prepaid expense is a company paying for a full year of insurance premiums in a lump sum at the beginning of the year. Even though the payment has already been made for 12 months, only the current month's premium is considered a current expense. The sum of the remaining 11 premiums is bucketed into a prepaid insurance account that is classified as a current asset on the balance sheet and in a working capital calculation. The prepaid insurance expense is then expensed as the insurance is used.

For example, Company ABC paid $1,200 for its yearly insurance in advance. The company books $100 as an insurance expense for the current month and $1,100 as a prepaid expense for the remaining 11 months. Meanwhile, the cash account is credited for $1,200. During month two, the company moves $100 from prepaid expenses to the insurance expense account by crediting prepaid expenses and debiting insurance expenses.