What Is Working Capital?
Working capital, also known as net working capital (NWC), is the difference between a company’s current assets, such as cash, accounts receivable (customers’ unpaid bills), and inventories of raw materials and finished goods, and its current liabilities, such as accounts payable. NWC is a measure of a company's liquidity and refers to the difference between operating current assets and operating current liabilities. In many cases, these calculations are the same and are derived from company cash plus accounts receivable plus inventories, less accounts payable, and less accrued expenses.
Working capital is a measure of a company's liquidity, operational efficiency, and short-term financial health. If a company has substantial positive working capital, then it should have the potential to invest and grow. If a company's current assets do not exceed its current liabilities, then it may have trouble growing or paying back creditors, or even go bankrupt.
- A company has negative working capital if its ratio of current assets to liabilities is less than one.
- Positive working capital indicates that a company can fund its current operations and invest in future activities and growth.
- High working capital isn't always a good thing. It might indicate that the business has too much inventory or is not investing its excess cash.
The Formula for Working Capital
To calculate working capital, compare a company's current assets to its current liabilities. Current assets listed on a company's balance sheet include cash, accounts receivable, inventory, and other assets that are expected to be liquidated or turned into cash in less than one year. Current liabilities include accounts payable, wages, taxes payable, and current portion of long-term debt. Current assets are available within 12 months. Current liabilities are due within 12 months.
The standard formula for working capital is current assets minus current liabilities.
Working capital that is in line with or higher than the industry average for a company of comparable size is generally considered acceptable. Low working capital may indicate a risk of distress or default.
Changes in Working Capital Affect a Company's Cash Flow
Most major new projects, such as an expansion in production or into new markets, require an investment in working capital. That reduces cash flow. But cash will also fall if money is collected too slowly, or if sales volumes are decreasing—which will lead to a fall in accounts receivable. Companies that are using working capital inefficiently can boost cash flow by squeezing suppliers and customers.
Frequently Asked Questions
How do you calculate working capital?
Working capital is calculated by taking current assets and deducting current liabilities. For instance, if a company has current assets of $100,000 and current liabilities of $80,000, then their working capital would be $20,000. Common examples of current assets include cash, accounts receivable, and inventory. Examples of current liabilities include accounts payable, short-term debt payments, or the current portion of deferred revenue.
What is an example of working capital?
To illustrate, consider the case of XYZ Corporation. When XYZ first started, it had working capital of only $10,000, with current assets averaging $50,000 and current liabilities averaging $40,000. In order to improve its working capital, XYZ decided to keep more cash in reserve and deliberately delay its payments to suppliers in order to reduce current liabilities. After making these changes, XYZ has current assets averaging $70,000 and current liabilities averaging $30,000. Its working capital is therefore $40,000.
Why is working capital important?
Working capital is important because it is necessary in order for businesses to remain solvent. In theory, a business could become bankrupt even if it is profitable. After all, a business cannot rely on accounting profits in order to pay its bills—those bills need to be paid in cash readily in hand. To illustrate, consider the case of a company that had accumulated $1 million in cash due to its previous years’ retained earnings. If the company were to invest all $1 million at once, they could find themselves with insufficient current assets to pay for their current liabilities.