Working capital costs (WCC) refer to the costs of maintaining daily operations at an organization. These costs take into account two different factors: the company’s short-term debt position and the current portion of long-term debt, which is generally the portion of debt due within the next 12 months. Both types of costs can be found on the company’s balance sheet in the current liabilities section.
- Working capital funds day-to-day operations and represents a company's ability to pay its current liabilities with its current assets
- The cost of working capital is related to a firm's current liability expenses relative to its current assets.
- The goal of working capital management is to maximize operational efficiency and reducing capital costs.
Which Items Are Included in Working Capital Costs?
Most companies have at least two types of accounts in the current liabilities section of their balance sheets: accounts payable and salary/wages payable. Beyond those, the specific items classified as current liabilities vary across companies and sectors as they are more dependent on which daily activities are core to the business.
For example, in the manufacturing sector, WCC is often described as the costs associated with converting raw materials to finished product. Significant portions of a manufacturer’s operating budget can be attributed to the purchase and storage of raw materials. A software company, on the other hand, might have larger portions of its current liabilities dominated by research and development (R&D) costs and marketing.
Measuring Working Capital for Liquidity Purposes
Working capital (WC) measures the company’s ability to fund day-to-day operations from its most liquid assets. Calculated as the difference between a company’s current assets and its current liabilities, WC is among the most common financial metrics used to decipher whether a company has sufficient liquidity available to meet its short-term requirements.
Companies whose current assets exceed their current liabilities are said to have positive WC, while those whose current liabilities exceed their current assets are said to have negative WC.
The Importance of Working Capital Management
Working capital is a daily necessity for businesses, as they require a regular amount of cash to make routine payments, cover unexpected costs, and purchase basic materials used in the production of goods.
When a company does not have enough working capital to cover its obligations, financial insolvency can result and lead to legal troubles, liquidation of assets and potential bankruptcy. Thus, it is vital to all businesses to have adequate management of working capital.
Working capital management is essentially an accounting strategy with a focus on the maintenance of a sufficient balance between a company’s current assets and liabilities. An effective working capital management system helps businesses not only cover their financial obligations but also boost their earnings.
Managing working capital means managing inventories, cash, accounts payable, and accounts receivable. An efficient working capital management system often uses key performance ratios, such as the working capital ratio, the inventory turnover ratio and the collection ratio, to help identify areas that require focus in order to maintain liquidity and profitability.
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 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.
According to the information above, the company's current ratio is 1.34:
- $36.54 billion ÷ $27.19 billion = 1.34