When a company has low working capital, it can mean one of two things. In most cases, low working capital means that the business is just scraping by and barely has enough capital to cover its short-term expenses. In other cases, however, a business with a solid operating model that knows exactly how much money it needs to run smoothly may have low working capital because it has invested its excess cash to generate investment income or fund growth projects, increasing the company's total value.
What Is Working Capital?
Working capital, also called net working capital, is simply the difference between the current assets and current liabilities figures on a company's balance sheet. Current assets are those things a business owns that can be turned into cash within the next year. This typically includes cash and cash equivalents, such as checking, savings, and money market accounts. Marketable securities such as stocks and bonds, mutual funds, and other highly liquid securities are also assets on the balance sheet.
- Working capital is the difference between current assets and current liabilities on a balance sheet and can be either positive or negative.
- Different types of companies need different levels of working capital to run smoothly.
- It can mean one of two things when a company has low working capital.
- Low working capital can often mean that the business is barely getting by and has just enough capital to cover its short-term expenses.
- However, low working capital can also mean that a business invested excess cash to generate a higher rate of return, increasing the company's total value.
A company's current assets also include its inventory because inventory should be sold within the coming year, generating revenue. Accounts receivable is also included because the item represents the value of sales that have been billed to customers but not yet paid.
Current liabilities are debts and expenses that must be paid within the next year. It includes the cost of supplies and raw materials needed to produce goods for sale, payments due on short-term debt, accounts payable or bills received but not yet paid, and interest or taxes due within the next 12 months.
Interpretation of Net Working Capital
Working capital can be either positive or negative. A negative figure often indicates financial distress and may be a sign of impending insolvency. However, very large companies with significant brand recognition and public support sometimes operate with consistently negative working capital because they can easily raise funds on short notice if the need arises.
Positive working capital can have a range of interpretations depending on the actual figure, the industry the business is in, and the specific business itself. Different types of businesses require different levels of working capital to run smoothly. Retail businesses, for example, require higher levels of working capital to cover increased expenses during high seasons. Online service businesses, conversely, typically require lower amounts of working capital since they provide no physical products and have stable operating expenses regardless of sales fluctuations.
If a company has a proven business model and stable finances, it may choose to invest in long-term assets that generate higher returns rather than keeping its capital in highly liquid short-term securities with lower yields. While this investment strategy can reduce the business' current asset total and its net working capital, a highly stable business with minimal expenses may decide the increased investment income warrants the reduction.
Similarly, a company may decide to take on new projects to expand the business, thereby increasing its current liabilities and decreasing its current assets and net working capital. In this case, a low working capital figure is indicative of a company focusing on growth while maintaining just enough liquidity to meet its current obligations.
The Bottom Line
Because the interpretation of a company's working capital can vary so widely, it is important to consider this metric in a historical context by noting patterns of increasing or decreasing figures over time. It is also necessary to compare a company's working capital figure to that of similar businesses within the same industry to ensure a fair and accurate analysis of its operational efficiency.