Working capital is the money used to cover all of a company's short-term expenses, including inventory, payments on short-term debt, and day-to-day expenses—called operating expenses. Working capital is critical since it is used to keep a business operating smoothly and meet all its financial obligations within the coming year.

Key Takeaways

  • Working capital is the money used to cover all of a company's short-term expenses, which are due within one year.
  • Working capital is the difference between a company's current assets and current liabilities.
  • Working capital is used to purchase inventory, pay short-term debt, and day-to-day operating expenses.
  • Working capital is critical since it's needed to keep a business operating smoothly.

Understanding How Working Capital Is Used

Working capital—also called net working capital—reflects the amount of money a company has at its disposal to pay for immediate expenses. Of course, the more working capital, the better it for a company's financial situation. The amount of working capital a company needs to run smoothly can vary widely. Some businesses require increased amounts of working capital to cope with expenses that ebb and flow seasonally.

For example, retail businesses often experience a spike in sales during certain times of the year, such as the holiday season. Retailers need an increased amount of working capital to pay for the additional inventory and staff that'll be needed for the high-demand season. As a result, a retailer would likely see higher expenses in the off-season relative to revenues leading up to the holidays.

Conversely, when sales are down in the off-season, the company would still need to pay for its normal staffing despite lower sales revenue. Working capital helps businesses smooth out the gaps in revenue during the times of the year when sales are slow.

Oftentimes, banks will lend to companies providing a working capital credit line, which allows companies to tap into during off-peak seasons when there are capital shortfalls. As a result, company executives as well as banks that lend to companies monitor working capital very closely. In order to understand a company's working capital needs, it's critical to know the specific items that can lead to increases or decreases in working capital.

Drivers of Working Capital

Companies have both short-term assets and liabilities. A company's short-term assets are called current assets, while short-term liabilities are called current liabilities. A company's working capital is the difference between the value of the current assets and its current liabilities for the period.

Current Assets

A current asset is an asset that is available for use within the next 12 months. Current assets are a company's short-term assets that can be easily liquidated—or converted into cash—and used to pay debts within the next year.

Current assets typically include:

  • Cash and cash equivalents—including cash, such as funds in checking or savings accounts, while cash equivalents are highly-liquid assets, such as money-market funds and Treasury bills
  • Marketable securities—such as stocks, mutual fund shares, and some types of bonds
  • Inventory—the merchandise that can be quickly sold or liquidated in less than one year
  • Accounts receivable or money owed to the company by its customers or other debtors for products and services sold

Current Liabilities

A current liability is a short-term expense that a company owes and must pay within a 12-month period. Current liabilities can include:

  • Short-term debt payments, which can include payments for bank loans or commercial paper issued to fund operations
  • Suppliers and vendors owed for inventory, raw materials, and services, such as technology support
  • Accounts payable, which are short-term bills owed 
  • Interest payments due to bondholders and banks, which can include interest owed on short-term debt as well as the current interest payments due for long-term debt
  • Taxes owed, such as income and payroll taxes due in the next year

The total amount of a company's current liabilities changes over time—similar to current assets—since it's based on a rolling 12-month period.

Interpreting and Adjusting Working Capital

Since working capital is equal to the difference between current assets and current liabilities, it can be either a positive or a negative number. Of course, positive working capital is always preferable since it means a company has enough to pay its operating expenses. However, the net working capital figure can change over time, causing the company to experience periods of negative working capital due to unexpected short-term expenses.

Conversely, a company that has consistently excessive working capital may not be making the most of its assets. While positive working capital is good, having too much cash sit idle can hurt a company. Those idle funds could be used for paying down debt, or investing in the long-term future of the company by purchasing long-term assets, such as technology.

Companies monitor their accounts receivables to determine when they're expected to receive payment from their customers. On the other hand, companies also monitor their accounts payables to determine the dates in which payments are due to suppliers. If the accounts payables are due sooner than the money due from the accounts receivables, the company can experience a working capital shortfall.

As a result, companies may offer incentives to their customers to collect the receivables sooner. Conversely, a company may also ask its supplier for better terms allowing the company to pay at a later date. Monitoring and analyzing working capital helps companies manage their cash flow needs so that they can meet their operating expenses in the coming months.