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

What Is Working Capital?

Working capital, also called net working capital, is simply the difference between a company's current assets and current liabilities. Working capital reflects the amount of money a company has at its disposal to pay for immediate expenses.

Since working capital is equal to current assets minus liabilities, it can be either a positive or a negative number. Of course, positive working capital is always preferable because it means a company has more money than it needs at a given moment. However, since the net working capital figure changes over time, as current assets and liabilities are based on a rolling 12-month period, even a healthy company may experience periods where its working capital is negative if it has 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 always a good thing, having a lot of cash on hand may mean the company is not investing its extra funds in the most lucrative manner possible.

What Is a Current Asset?

A current asset is an asset that is available for use within the next 12 months. This refers to anything the company owns that can be liquidated, or turned into cash, and used to pay debts within the next year. Current assets typically include cash and cash equivalents, marketable securities, inventory and accounts receivable.

Cash includes any actual liquid cash, as well as checking or savings accounts. Cash equivalents include other highly-liquid assets, such as money market mutual funds and government-issued bonds. Marketable securities include stocks, options and mutual fund shares. Inventory is included because the company most likely turns back stock of products into revenue within the coming year, unless the product fails to sell. Accounts receivable includes any amounts that have been billed to customers or other debtors but have not yet been paid.

What Is a Current Liability?

A current liability is any expense a company must cover within a 12-month period. This includes the following:

  • Payments required on short-term debts
  • Payments to vendors and suppliers
  • Accounts payable or bills that have been received but not paid
  • Interest due to bondholders
  • Income or payroll taxes due for the year

Like current assets, the amount of a company's current liabilities changes over time since it is based on a rolling 12-month period.

How Much Working Capital Does a Company Need?

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 and need increased working capital to pay for the additional inventory leading up to the high-demand season. This may mean the company actually spends more in the off-season relative to its revenues than it does in the on-season to prepare for the influx of customers.

When sales are down, the company still has to pay for normal inventory and payroll even though it is not generating the same amount of revenue. Regardless of the business type, maintaining sufficient working capital throughout the year is one of management's primary concerns.

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