Working capital is a common metric used to measure a company's liquidity or its ability to generate cash to pay for its short term financial obligations. Working capital also provides insight into the operational efficiency and overall financial health of a company. 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 to pay bills, and buy raw materials used in production.

Key Takeaways

  • Working capital is a metric used to measure a company's liquidity or its ability to generate cash to pay for its short term financial obligations.
  • Working capital is the difference between a company’s current assets, such as cash, and its current liabilities, such as its debts.
  • A company that has positive working capital indicates that it has enough liquidity or cash to pay its bills in the coming months.
  • Working capital provides insight into the operational efficiency and overall financial health of a company.

Working Capital as a Measure for Liquidity

Working capital is the difference between a company’s short-term assets, such as cash and its short-term liabilities, such as its debts or bills. A company that has positive working capital indicates that the company has enough liquidity or cash to pay its bills in the coming months.

For a company, liquidity essentially measures its ability to pay off its bills 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.

Drivers of Working Capital Liquidity

The two components of working capital are called current assets and current liabilities, which are described in detail below.

Current Assets

Current assets are the assets that a company owns that are expected to be used up within the next 12 months. Examples of current assets include:

  • Cash and cash equivalents
  • Accounts receivable, which are the payments owed by customers for products and services sold
  • Inventory, which can consist of merchandise and finished goods that can be liquidated or sold to raise cash
  • Marketable securities, which are investments that are not locked up and can be easily redeemed for cash
  • Prepaid expenses include any payments to contractors or vendors for services not yet received

Current Liabilities

Current liabilities are the short-term debts or bills that a company owes within the next 12 months and are typically paid for by using current assets. Examples of current liabilities include:

  • Accounts payable, which are debts owed to suppliers and vendors
  • Wages payable that are due to employees within the next year
  • Short-term debt, which includes bank loans used to fund the company's operating expenses
  • Dividends payable, which are cash payments due to equity shareholders as a reward for being an investor in the company
  • Current portion of long-term debt that's due in the next 12 months
  • Interest payable on outstanding debts, including long-term obligations
  • Income taxes due within the next year

Interpreting Working Capital Liquidity

Working capital is the measure of how well a company can sell its current assets to pay its current liabilities. For example, if a company has an accounts payable coming due in 30 days, the company could sell some of its merchandise inventory or withdraw cash from its marketable securities to satisfy the payable that's coming due.

However, if that same company didn't have enough merchandise inventory, or any cash on hand, or marketable securities, it could run into difficulty paying its accounts payable. As a result, investors and equity analysts, as well as banks that extend credit to companies, analyze whether a company has the current assets to cover its current liabilities.

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, accounts receivables, inventory, and portions of debt due within one year.

For example, a company can improve its working capital by collecting their accounts receivables from their customers sooner or asking suppliers for a short-term extension on the due dates for their accounts payables. A number of factors affect working capital needs, including asset purchases, past-due accounts receivable being written off, and differences in payment policies. However, it's important to remember that the working capital needed to operate a business varies between industries.

Positive Working Capital – Liquidity

A company that has an excess of current assets to meet its current liabilities has positive working capital. A company with the ability to generate cash puts the company in a better position to weather any upcoming storms or challenges. Below are a few of the ways that positive working capital affects a company's operations.

Banks

Positive working capital can help a company obtain credit and better terms for loans from banks. The better credit terms might mean a lower interest rate on long-term debt or the ability to establish a working capital credit line with a bank. A credit line is a credit facility that banks provide businesses so that they can tap into when needed. Once enough revenue has been generated, the credit line is paid off, and the company again has access to that liquidity if needed in the future.

Suppliers

Also, suppliers and vendors that allow companies to pay them back via an accounts payable are essentially extending credit to the company. A payable might be due in 30, 60, or 90 days. The company would use the supplies that were bought on credit to manufacture their product and generate sales. The revenue from those sales would be used to pay off their accounts payables due to the suppliers.

Before a supplier would agree to an accounts payable, they would need assurances that the company is financially viable. Measuring the company's working capital enables the supplier to ascertain whether the company has the financial resources to pay them back.

Excessive Liquidity

Conversely, too much working capital could mean a company is not adequately using its cash. A company with an excessive amount of working capital might be better off putting the money to use by purchasing new equipment, hiring workers to boost production or sales, or paying down debt.

Negative Working Capital – Inadequate Liquidity

Negative working capital can indicate short-term cash issues or a more serious long-term management issue if it's persistent. Below are a few of the reasons why a company might experience negative working capital.

Cash Outlays

Negative working capital could be caused by a company making a large cash outlay for buying equipment or paying down debt. Many companies experience periods of negative working capital, which is why many of them have working capital credit lines established with their bank. In other words, brief periods of negative liquidity might not be a reason for concern and should be compared with other companies within the same industry.

Seasonal Businesses

A company that sells products in a seasonal business might spend a lot of cash and need to borrow from a bank to hire workers, buy inventory, and raw materials leading up to their busy season. The company would show negative working capital during this time as they ramp up production. However, once the seasonal sales start coming in, the revenue generated is used to pay their accounts payables, short-term debt, and borrowing facilities.

Retailers, for example, typically generate the vast majority of their sales during the holiday season. As a result, the working capital for these companies can fluctuate wildly throughout the year.

Long-term Issues

However, companies that are struggling financially will typically have negative working capital for an extended period. Negative liquidity is a red flag for investors and creditors since it could be symptomatic of poor operational management, debt management, and mismanagement of their payables and receivables. For example, if a company's customers aren't paying them on time, it can create a cash flow shortfall, leading to late payments on their bank debt and accounts payables.