Working capital is a commonly used metric, not only for a company’s liquidity but also for its operational efficiency and overall financial health. A company’s working capital is the capital necessary for it to function on a daily basis, as it requires a certain amount of cash on hand to cover unexpected costs, make regular payments and buy raw materials used in production.
Working Capital as a Measure for Liquidity
Working capital is the difference between a company’s current assets and current liabilities. The working capital ratio indicates to analysts the company’s liquidity or whether it has cash flow adequate enough to meet all of its short-term liabilities and expenses. It is calculated by dividing current assets by current liabilities.
The working capital needed to operate a business varies between industries. A number of factors affect working capital needs, including asset purchases, past-due accounts receivable (AR) being written off, and differences in payment policies.
Working capital reflects various company activities, such as debt management, revenue collection, payments to suppliers and inventory management. These activities are reflected in working capital, as it includes not only cash but also accounts payable (AP) and AR, inventory, portions of debt due within one year and some other short-term accounts.
For a company, liquidity essentially measures its ability to pay off its liabilities when they are due, or how easily and effectively a company can access the money it needs to cover its debts. Working capital reflects the liquid assets a company utilizes to make such debt payments.