What is Working Capital
Working capital, also known as net working capital, is the difference between a company’s current assets, like cash, accounts receivable (customers’ unpaid bills) and inventories of raw materials and finished goods, and its current liabilities, like accounts payable.
Working Capital = Current Assets - Current Liabilities
BREAKING DOWN Working Capital
Working capital is a measure of both a company's operational efficiency and its short-term financial health. The working capital ratio (current assets/current liabilities), or current ratio, indicates whether a company has enough short-term assets to cover its short-term debt. A good working capital ratio is considered anything between 1.2 and 2.0. A ratio of less than 1.0 indicates negative working capital, with potential liquidity problems, while a ratio above 2.0 might indicate that a company is not using its excess assets effectively to generate maximum possible revenue.
If a company's current assets do not exceed its current liabilities, then it may have trouble paying back creditors or go bankrupt. A declining working capital ratio is a red flag for financial analysts.They might also look at the quick ratio, which is more of an acid test of short-term liquidity because it only includes cash and cash-equivalents, marketable investments and accounts receivable.
Changes in Working Capital Affect a Company's Cash Flow
Most projects require an investment in working capital, which 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.
Things to Remember
- A company has negative working capital If the ratio of current assets to liabilities is less than one.
- A high working capital ratio isn't always a good thing. It might indicate that the business has too much inventory or is not investing its excess cash.